Seðlabanki Íslands - Company Announcement

- Policy interest rate unchangedm - The arguments for decision

Policy announcement by  the Board of Governors of the Central Bank of Iceland:  

Policy interest rate unchanged                                                  

The Board of Governors of the Central Bank of Iceland has decided to leave the  
Bank's policy interest rate unchanged at 13.75%. The inflation forecast that was
published in the November issue of Monetary Bulletin envisaged an unchanged     
policy rate until mid-2008. Inflation has been higher than expected in the last 
two months and is now higher than is consistent with the Bank's inflation       
forecast from November. Aggregate demand growth in the third quarter was        
stronger than forecast, and indicators imply that the strong momentum will be   
sustained in the fourth quarter. The near-term inflation outlook is therefore   
less favourable than it was when the last policy rate decision was made, but the
long-term inflation outlook has not changed materially.                         

Conditions on global financial markets have continued to deteriorate. As a      
result, and because of the high policy rate, domestic interest rates have risen 
sharply since the Central Bank's last policy rate decision, while the supply of 
credit has diminished. Interest rates on long-term indexed bonds, which earlier 
were slow to respond to tightened monetary policy, have risen sharply this year,
especially since the policy rate hike in November. Equity prices have also      
dropped substantially in the past few months, raising the financing cost of     
businesses and weakening their balance sheets as well as those of households.   
These developments are likely to lead to lower real estate prices in the time   
ahead, as has occurred in many countries, affecting inflation directly, through 
the housing component of the CPI, and indirectly, through dampened domestic     
demand.                                                                         

Unfavourable financial conditions and falling asset prices will reduce demand   
and ease inflationary pressures. This could be offset by a depreciation of the  
króna, which is still high in an historical context. The continued strength of  
the króna is dependent on foreign investors' desire to take advantage of the    
interest rate differential and thereby fund Iceland's current account deficit.  
While the deficit has narrowed faster than previously expected, the underlying  
imbalance is still sizable.                                                     

The assessment of the Board of Governors is that, as yet, the long-term         
inflation outlook presented in the November issue of Monetary Bulletin has not  
measurably changed. Offsetting higher short-term inflation and a larger output  
gap are the sharp impact of the November policy rate increase on other domestic 
interest rates - particularly rates on indexed loans - and the tightening effect
of deteriorating global financial market conditions. These conditions will      
reduce domestic demand. It is the Board's assessment that by maintaining the    
policy interest rate at the current level the inflation target can be attained  
within the time frame envisaged in the November baseline forecast; that is,     
around mid-2009.                                                                

If wage and exchange rate developments prove less favourable than assumed in    
November's baseline forecast, disinflation could be delayed. Contractual wage   
negotiations are underway, and higher inflation makes that complex process even 
more difficult. As there are still no unequivocal signs that labour market      
pressures are abating, it is possible that wage developments will exert more    
inflationary pressure than was assumed in November. If this happens, or if      
inflation rises for other reasons, the Board of Governors will respond          
appropriately.                                                                  


The next policy interest rate decision by the Board of Governors of the Central 
Bank will be announced on February 14, 2008.