Iceland's central bank may raise interest rates at its next meeting if inflation accelerates further, said governor Mar Gudmundsson who sees an equilibrium rate at between 4 and 5 per cent.
The small Nordic country's central bank said last month the likelihood of an increase in rates was now bigger than a cut. But, Gudmundsson cautioned yesterday that any tightening move would be limited and should not harm the economy, which is recovering after the 2008 collapse of its banking system.
"There is always a risk but I don't think there is a big risk because I don't foresee that, if we were to tighten in the next few months, we would be talking about anything major or big steps," Gudmundsson said.
Gudmundsson, who was speaking on the sidelines of a business forum, said inflation data in August and September would be crucial to determine whether the central bank needs to increase its key policy interest rate.
"We now have a tightening bias. A bias is a bias. It is not a foregone conclusion that we will tighten at the next meeting but it could happen," he said.
Iceland plunged into recession in 2009 after its biggest banks collapsed when credit dried up globally. The banks' liabilities were eight times greater than the country's gross domestic product.
The central bank has managed to stabilise the currency with capital controls, cap inflation and lower interest rates to 4.25 per cent from a peak of 18 per cent two years ago.
But headline inflation has increased in recent months due to a weak crown and higher commodity and oil prices. Iceland's consumer price index (CPI) rose 4.2 per cent in June from the same period a year ago compared with 3.4 per cent in May. "We will be looking at the development of inflation itself and see to what degree it is driven by temporary or more permanent factors," Gudmundsson said, adding June's data had come in "more or less as we expected".
The central bank has an inflation target of 2.5 per cent and a fluctuation margin of 1.5 percentage point in either direction, he said.
Gudmundsson estimated that an equilibrium interest rate for Iceland was "in the region of 4 to 5 per cent".
Iceland's central bank is faced with the challenge of gradually loosening capital controls, which Reykjavik imposed at the height of the crisis, without destabilising the crown.
A central bank-led group outlined in March 2011 a plan to phase out controls. The first phase gives foreign investors holding crowns the chance to swap them for foreign currencies.
Gudmundsson did not say when controls would be entirely removed, saying this depended on signs they were successful.
The crown remains undervalued, he said, although he expected it to "correct somewhat in the months and quarters to come". The crown has lost 8 per cent against the euro this year.
Gudmundsson also said he did not think Greek's debt issues, which have shaken the euro in recent months, affected Iceland's negotiations to join the European Union and the bloc's single currency. "The application process is going on."
The OECD now expects Iceland's economy to grow by 2.2 per cent this year and 2.9 per cent in 2012. The country's progress was underlined when Iceland returned last month to the international bond market for the first time since the crisis, borrowing $1 billion (Dh3.67 billion).
Gudmundsson said the decision to tap the market was not based on a particular need for foreign currency.
"We did it in order to rebuild confidence but these loans in the IMF programme need to be financed so we will have at some point to come back in the market," he said, referring to the International Monetary Fund's $2.1 billion loan programme.
From / Gulf News