The industry was and still is clamouring for an interest rate cut. As of March 24 2008, Iceland’s rates stood at 13.75 per cent, far and away the highest in Europe excluding Turkey. The country’s central bank met in February to discuss a cut but, as expected, left rates alone. Analysts were disappointed, but they were convinced that the bank would ultimately cut rates in the spring.

And then, on March 25, the bank shocked everyone by raising rates to 15 per cent.

In a statement, the bank said: “Inflation has been higher than forecast and inflation expectations have risen. Demand has also been stronger than expected. The exchange rate of the krona has depreciated more than entailed in an alternative scenario published in the monetary bulletin in November.”

Indeed, its currency and domestic inflation are out of control. So far this year, the Icelandic kroná lost over 20 per cent of its value compared to the euro. This has created concerns that the government will not be able to finance a current account deficit of 16 per cent of the country’s GDP. Meanwhile, inflation was 6.8 per cent in February. Then, adding insult to injury, it raised rates again to 15.5 per cent.

While Icelandic funds and asset managers had anticipated February’s decision, the recent hikes were regarded as a slap in the face.

An Icelandic fund manager, who spoke on the condition of anonymity, likened the current situation to a party that was almost over but someone at the central bank found an old bottle of dusty gin that they would try to drink to make the good times continue.

He said: “It is ridiculous. What are you supposed to do when the central bank becomes a rogue trader? This is a continuation of an imbalanced policy. At best it is a very short-term fix, but it is completely unsustainable.

“They are mixing two policies into one and it is a recipe for disaster. You’re going after a monetary-based policy with inflation targeting, but you are stuck with focusing on the exchange rate. If you do that, in practice you’ve shifted the policy from inflation fighting to the currency. And that doesn’t work.”

Icelandic pension funds were not as critical, but there certainly appears to be some fear.

Stefan Halldorsson, chief executive officer for the €300m Engineers’ Pension Fund says he sees some positive and negative aspects to the rate hike.

He says: “The positive side is the fact that they have acted, and acted outside their listed decision dates, which shows that their awareness and willingness to correct the situation is good.

“However, I think that my fund and probably many others feel uncomfortable with the situation and this is clearly not a convenient situation to be in. If you look at it from the point of rates, bonds are attractive but on the other hand it increases the likelihood of defaults so there is a limit to how much you can expect to gain. We would be more comfortable with lower pressure in the system.”

Mr Halldorsson adds that to deal with the current situation the fund could take short-term measures such as cutting some of its positions in equities. He also said that, while the fund in the long term would like to increase its allocation to foreign equities, the devaluation of the krona had made this too expensive, so it would be forced to look domestically for short term equity gains.

Yet, oddly and despite the concerns, markets reacted well to the rate hike. The day of the first increase the OMXI15 share index on the OMX Nordic Exchange in Iceland rose by 6.16 per cent, a record increase. Coinciding with the rise, the krona appreciated by 3.7 per cent.

Research from Icelandic bank Glitnir said: “Under normal circumstances a rate hike would have affected the stock market negatively as the opportunity cost of share holdings rise when short-term interest rates rise.

“However, in the current circumstances, it is not surprising that the rate hike induced a rise in share prices as the market is highly sensitive to all news and hungers for reports indicating that a turnaround is on the horizon.”

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