The Central Bank Of Iceland Raises Interest Rates And Widens The Exchange Rate Band For The Króna

After consultation with the government, the Central Bank of Iceland has decided to widen the exchange rate band for the króna from ±6 percent to ±9 percent, effective Monday February, 14 2000. The change is intended to create scope for further monetary tightening that may be required in order to reduce inflation. The Central Bank of Iceland has also decided to raise the Bank's interest rates by 0.3 percentage points. The interest rate increase is intended to restore the interest rate differential with trading partner countries prevailing before recent interest rate hikes in Europe and the United States and to underscore the intension of the Central Bank to use the enhanced flexibility of the exchange rate policy to reduce inflation. The widening of the exchange rate band is a further step in a process towards greater exchange rate flexibility. In September 1995, the band was widened from ±2¼ percent to ±6 percent. This was mainly a precautionary measure motivated by the removal of restrictions on short-term capital movements at the beginning of 1995. In practice, however, the exchange rate remained within the old band until May 1998. In the wake of wage settlements in 1997, monetary tightening led to an appreciation of the króna, moderating the inflationary impulse resulting from the wage settlement. Last year, however, inflation rose significantly. Consequently, monetary policy was tightened causing the króna to appreciate in the second half of the year. The exchange rate of the króna peaked on December 28, 1999, when it was 4.9 percent above the central rate, i.e. 1.1 percent within the upper limit of the band. The Central Bank has not intervened in the exchange market since the middle of June 1999. In the view of the Central Bank, controlling inflation must continue to be given a priority. After the exchange rate of the króna peaked in December it appeared that the upper limit of the exchange rate band was an obstacle to a further appreciation, even though the band technically still provided some scope for appreciation. By widening the exchange rate band, the Central Bank wants to remove an impediment to a further tightening of monetary policy. The widening of the exchange rate band and the increase in interest rates clearly reinforce the intention of the Central Bank to give priority to price stability in its conduct of monetary policy.