- Monetary policy statement by the Board of Governors of the Central Bank of Iceland - Policy rate remains unchanged

The Board of Governors of the Central Bank of Iceland has decided to leave the
Bank's policy interest rate unchanged at 15.5%. 

Economic indicators are divergent at present. Inflation rose sharply in the
wake of the depreciation of the króna during the first months of the year,
however, it remains likely that inflation is near its peak and will unwind
quickly over the coming year. The króna is weaker than was projected in July,
and the real exchange rate is at a historical low. Furthermore, recent figures
indicate stronger output growth than previously forecast, which suggests that
the disinflation process could be somewhat slower than assumed in July. In
addition, the real policy rate has declined in recent months, as a result of
increased inflation and higher inflation expectations. Several factors offset
this, however: consumer sentiment indices have declined sharply, access to
credit has tightened, and high interest spreads complement restrictive monetary
policy. 

The national accounts published this morning show that, in spite of a
contraction in private consumption, GDP growth was considerable in the second
quarter of 2008, due in particular to growth in exports. Output growth in 2007
and Q1/2008 was also stronger than previous estimates indicated. While it would
be imprudent to draw broad-based conclusions from statistics for a single
quarter, it is noteworthy that these statistics concur with known indicators.
The labour market survey for Q2 reveals robust employment growth year-on-year,
and unemployment is hardly discernible in spite of a rise in redundancies.
 
The Central Bank considers it likely that GDP will contract over the next two
years despite the unexpected vigour in the economy this year. A contraction is
an inevitable element in the economy's adjustment towards a sustainable
equilibrium following a period of very strong growth, and it will help the
Central Bank to reign in inflation. Adopting stimulative measures under the
current conditions - by relaxing monetary or fiscal policy - would be
inappropriate and ill-timed. Such measures would undoubtedly delay the
adjustment of the economy, weaken the króna, promote higher inflation, and
raise inflation expectations. Such a policy will ultimately lead to an even
sharper economic contraction. It will weaken the balance sheets of indebted
households and businesses and undermine financial stability. It is vital that
fiscal policy supports monetary policy in reducing inflation and contributing
to internal and external balance in the economy. 

In the recent term, the Central Bank and the Government have worked together to
bolster confidence in the financial system and enhance financial market
functioning. Swap agreements have been concluded with Nordic central banks,
certificates of deposit have been issued, Treasury note issuance has been
expanded, and the foreign exchange reserves have been strengthened
substantially. The global credit markets are in a deep slump, and risk premia
are high in general as a result of the prevailing lack of confidence. It is
inadvisable and pointless for a debt-free Treasury to accept unreasonable terms
under unusual market conditions; therefore, the Central Bank has strengthened
its foreign exchange reserves in prudent increments. Furthermore, the Bank has
amended its rules on collateralised lending to financial undertakings so as to
align them with those of the European Central Bank. The Central Bank of Iceland
will continue to reinforce the infrastructure of the financial system. 

It is necessary to keep the policy rate high until inflation and inflation
expectations have begun to move decisively toward the inflation target. To
vacillate now would be worse for all in the short and long term. Monetary
policy must provide the restraint that is necessary to reduce inflation and
inflation expectations. Spiralling wages, prices, and exchange rates are a
known driver of inflation in Iceland. If the public and private sectors make a
commitment to support the Central Bank in its efforts to control inflation,
that effort will expedite the reduction of the policy rate and the recovery of
the economy and will bolster disposable income for the long term.