Iceland's central bank raised its key interest rate by a record 1.25 percentage points at an emergency meeting to halt a slump in the krona and a surge in inflation. The currency made its biggest ever jump against the euro.
Sedlabanki raised the repo rate to 15 percent, the Reykjavik- based bank said on its Web site today. It hadn't planned to hold a rate meeting until April 10. It was ``crucial'' to reverse the krona's decline ``as quickly as possible,'' the bank said.
The krona tumbled 17 percent against the euro in the past three weeks on concern that the global financial turmoil would make it harder for Iceland to finance one of the world's largest current account deficits. The country risks ``spiraling'' wages and inflation if that decline isn't pared, the central bank said. Inflation reached a one-year high of 6.8 percent last month.
``They were losing the battle with inflation,'' said Ludvik Eliasson, an economist at Iceland's No. 2 lender, Landsbanki Islands hf. ``Inflation expectations were rising significantly over the past few weeks on the decline of the krona. They had to do something convincing.''
The krona gained as much as 5.3 percent against the euro after the surprise announcement and was trading at 117.655 as of 2:39 p.m. in Reykjavik. It jumped as much as 6.3 percent to 74.21 per dollar, the most since the Icelandic currency first traded freely in 1993.
The country's benchmark index of the 15-most traded stocks leaped 5.1 percent, the biggest leap in six-and-a-half years.
`Tight Monetary Policy'
Inflation has exceeded the central bank's 2.5 percent target every month since April 2004, while the current account shortfall stood at 15.6 percent of the economy last year, according to combined statistics office and central bank data.
``It will be necessary to continue to pursue a very tight monetary policy in order to bring inflation and inflation expectations under control and increase confidence in the krona,'' the central bank said in a statement today.
Inflation probably quickened to 8.4 percent this month, according to the median estimate of five economists surveyed by Bloomberg.
``The real exchange rate of the krona is now very near a long-term historical low,'' the central bank said. ``If that development is not reversed'' then ``a period of persistent inflation would be ahead with spiraling increases in prices, wages and the price of foreign exchange.''
Krona Weakness
This year's slump in the krona represents the second time investors have shunned the currency since 2006. The krona lost 20 percent against the euro that year, sparked by concern the current account gap was unsustainable.
The currency recovered in 2007 as inflation slowed and the current account narrowed. This year's global financial turmoil has once again undermined confidence in the currency.
``Deteriorating financial conditions in global markets mean that it has become more difficult to finance the current account deficit,'' the central bank said. ``Adjustment of the national economy with a contraction of demand will thus not be escaped.''
The current account deficit, which was equivalent to a quarter of the $16 billion economy in 2006, has been slow to improve after aluminum companies including Alcoa Inc. delayed production. At the same time, quota restrictions on the fishing industry are hampering the island's other major export.
Adding to pressure on the current account, unemployment at 1 percent is fueling wage growth, which accelerated to an annual 6.8 percent last month. That's lifting demand for imports.
Trade Gap
The country's trade gap more than doubled in February from the year earlier, the statistics office said on March 5, after exports slumped 18.3 percent and imports grew 10.6 percent from a year earlier.
Some investors have also hesitated to keep positions in an economy whose gross external debt stood at five times the size of the economy last year, with more than 80 percent of that stemming from the country's biggest lenders.
The central bank will publish an economic outlook next month when it announces its next rate decision.
``A side-effect of the financial crisis has been to make it more difficult for the economy to finance the especially hefty current account deficit, which can make rate hikes necessary to attract the necessary capital,'' said Thomas Jensen, an economist at Handelsbanken in Copenhagen.
The central bank also took steps to boost bank industry solvency as a global credit crunch makes access to funding difficult. Banks will no longer be required to include obligations at foreign branches when setting reserve levels.
``It can be expected that this change will considerably lighten the reserve requirements of those banks that operate branches abroad,'' the bank said.
The bank will also issue transferable certificates of deposit, raising liquidity, it said.
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