Three months after I posted about Iceland's colossal struggle with inflation, that epic economic battle rages on. Inflation remains on the rampage. The policy rate stands at 15.50%. Early hints of a potentially substantial recession have begun to manifest themselves.
Some highlights from the Sedlabanki's July 3, 2008
monetary policy report:
Today, Iceland's central bank held its benchmark interest rate at 15.50%, as inflation continued to rise. The year-on-year inflation rate in June came to 12.7% vs. the 8.7% figure for March. Inflation is now running at an 18-year high and inflation expectations remain unanchored.
Furthermore, the embattled central bank noted that wage increases will likely prolong the period of excessive inflation. With inflation running some 10 percentage points above the central bank's target, the central bank has warned that it will need to retain the current high rate of interest and perhaps increase it further. Should wages continue to increase, the central bank has suggested that the policy rate could be increased and possibly to as high as 17%.
At the same time, in a
press conference on May 23, the central bank's chairman of the Board of Governors Davíđ Oddsson suggested that the bank would maintain high interest rates until the excessive inflation receded. At that news conference, he was asked, "How long does the Central Bank believe businesses in Iceland can tolerate these high interest rates?"
He responded:
It is abundantly clear that this high interest rate is not a pleasant thing for anyone in need of market funding, but it is the only tool that we in this Bank have in order to unwind the significant inflationary pressure in the economy, and we must use it. Various other tools can be used as well, but it is in other people’s hands to ensure that they are also used. But to answer directly, we expect that when the economy slows down, interest rates can begin to taper off, and the downward cycle can take place in an orderly manner when that time comes.
Nevertheless, there are now some early signs that a significant recession could be approaching. Total hours worked among Icelanders fell for the first time since the Fourth Quarter in 2004. Iceland's real disposable income has fallen by around 4% since last year, its biggest decline since the early 1990s. Residential investment is now forecast to "contract significantly" and a decline in housing prices could, in the central bank's opinion, help roll back inflation.
Furthermore, Iceland's central bank now anticipates a serious recession. Between now and the end of 2010, real disposable income is projected to decline 11% and real private consumption is expected to fall 15.5%. Home prices are forecast to 19% in nominal terms and around 30% in real terms. That downturn in home prices has already begun. Real GDP is forecast to contract about 2.0% in 2009 and 1.9% 2010. The overall real contraction would amount to approximately 3.9%. To put things into context, no U.S. recession since 1950 has seen such a large decline in real GDP.
As per the central bank's alternative scenarios, the two biggest risks that could further exacerbate and prolong the excessive inflation would be a sharp decline in the króna in the foreign exchange markets and/or large wage hikes. On the other hand, a sharper than expected deterioration in the housing market could dampen inflation.
All said, Iceland's epic struggle with inflation continues. However, three months later, there are the first indications that Iceland's high interest rates may be giving rise to a significant economic contraction that could ease the inflationary pressures.