Another month, another report on Iceland’s economic outlook. This time it is the Paris-based Organization for Economic Cooperation and Development, which in its latest mixed review of the Nordics’ fortunes calls for Sedlabanki – Iceland’s central bank – “to establish credibility”.

Inflation is running at an annual rate of 8.6 per cent, quite a way from Iceland’s monetary framework target rate of 2.5 per cent. Indeed, it has exceeded this target since 2004, a trend the OECD expects to continue.

The inflation rate hits bond yields, and looking at the other side of the coin – short to medium-term bond yield differentials – the OECD believes that the outlook for inflation has worsened. The increase in the inflation premium – the difference between indexed and non-indexed bonds with the same maturity – follows the Krona’s depreciation earlier this year.

Bjorn Gudmundsson, research analyst with Landsbanki, told nrpn there have been “considerable falls in bond yields over the past two or three weeks”. He adds that the falls have been more or less across the line on both nominal and real returns.

The more bullish attitude towards krona-denominated bonds could be driven by market participants pricing in a swifter slowdown in interest rate increases. This expectation is surprising given the recommendation from the OECD that Sedlabanki “needs to raise interest rates substantially so that inflation is brought back to the target”.

Central bank

It is all the more surprising given recent tough talking from Sedlabanki. Back in August 2005, following a 75bp rate hike, Ingimundur Fridriksson, the bank’s deputy governor, told nrpn that Iceland’s monetary authority “means business”. Subsequent deeds matched his words.

“Credibility is a tricky issue that you do not win or gain on a short-term basis. I’m not certain if talking tough is necessarily conducive to winning credibility – you need to be subtle,” says Mr Gudmundsson.

He suspects that Sedlabanki might shift the focus of its inflation-strategy from the single blunt weapon in its armory of rate rises. Equally, Sedlabanki does not bear sole responsibility for the success or failure of Iceland’s economic strategy. Peculiarly absent from recent debate has been any reference to the country’s political (fiscal) leaders.

“Iceland needs a strong fiscal policy to counterbalance the monetary authority,” says Mr Gudmundsson. “Sedlabanki needs to get the message across to the fiscal authority that they need to do their bit, especially on winning confidence.” Questions of confidence or not, the picture remains mixed, with renewed interest among foreign investors for both indexed and non-indexed bonds, a development that Bjorn Gudmundsson thinks market watchers “did not anticipate”.

Market watchers, however, might prefer to wait before rushing to price in a slowdown in policy-rate increases. “At some stage we will bring inflation under control,” says Ingimundur Fridriksson, “and rates will peak,” all of which seems obvious enough. But he warns: “We have not said anything about when or where that will be. All we said in connection with the rate rise of August 16 is that the time had not yet come to announce an end to rate increases.” Sedlabanki’s 0.5 per cent hike took its policy rate to 13.5 per cent.

The outlook for domestic equities, says Mr Gudmundsson, is also brighter than might be expected. True, stellar annual returns of 64.7 per cent posted in 2005 are a thing of the past – relative to the start of the year, equities are up by around 7.2 per cent, leaving the Icex-15 index more or less where it started out the year.

Fiscal policy

The call for a strong fiscal policy is echoed – obliquely – by the OECD. Although the Paris-based economic watchdog calls for the government “to ensure that its agreement with central bank on the inflation target is being implemented”, it also calls for “the expansionary effect of tax cuts needs to be offset by additional spending restraint so long as there is no clear evidence that the economy is cooling down.” In practice, says the OECD, this could mean pay restraint and delaying public investment, with a warning that “spending overruns remain an issue”.

Since publication of the OECD’s report in August, signs have emerged from early sparse data that the economy is slowing. Bjorn Gudmundsson says: “The housing market is the key to any downswing in the economy. The effect of the krona’s depreciation in February are starting to come through and have a cooling effect on the economy.”

And it is against this background that he questions whether further tough talking from Sedlabanki is appropriate. He says: “The economy seems to be turning around rather quickly. I would like them to balance the message. To some extent they did that in their announcement on 16 August, so maybe we are seeing that change.”

• A summary of the report’s main findings is available online at: www.oecd.org/eco/surveys/iceland

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INTEREST RATES HIKED TO RECORD LEVELS

The central bank of Iceland pushed interest rates up by 0.5 percentage points to a record 14 per cent on Thursday 14 September – the seventeenth rate rise in two years.
"We are not going to stop raising rates until we see clearer signs that inflation is decreasing," central bank governor David Oddsson told a news conference in the Icelandic capital after the bank announced the rise.
“Economic developments since the beginning of July have unfolded broadly in line with the macroeconomic and inflation forecast published, except that the rate of inflation in Q3 has turned out somewhat lower,” the bank added in a statement.

CN