Interest rates might have to rise further
The Central Bank of Iceland should maintain the strong reins of monetary policy until there is clear evidence that inflation will rebound to a 2.5% inflation target and inflation expectations have again been restored in line with the target.
This is among the recommendations of the IMF delegation following a review of the Icelandic economy and employment in 2023.
To achieve this, the CBI’s policy rate may have to rise further from the current level, and the bank’s real interest rate may have to remain above the neutral level for as long as necessary, especially under conditions of overheating economy and more persistent inflation on a broad basis, as indicated in the opinion of the delegation.
Less growth and more inflation?
The prospects for growth are rather positive in the view of the IMF delegation, but they are accompanied by imbalances and are subject to significant risks. However, the review points out that economic growth could be lower and inflation could be higher than currently apparent and that tighter international financial conditions could lead to higher funding costs for Icelandic banks that rely on international financing.
The mission notes that failures in central bank monetary policy in foreign developed countries could lead to a continuation of high imported inflation, which would give rise to tighter controls here. Further labour tensions are possible, which could disrupt economic progress and lead to collective bargaining that increases inflationary pressures, according to the mission.
Iceland has shown great resilience
The mission’s opinion states that Iceland has shown great resilience against a series of external shocks since 2019, but under conditions of overheating economy and inflation well above target, it is necessary to increase restraint in economic governance while simultaneously protecting the position of the least well-off.
The delegation also believes that it is time to include structural reforms in the new sector, which should facilitate greater diversification and improve sustainability and productivity in traditional export sectors, including tourism. The coming round of negotiations provides an opportunity to reconcile real wages with productivity gains, according to the delegation.