Iceland unexpectedly raises rates to 15%

Iceland unexpectedly raises rates to 15%By Robert Cookson in London Published: March 25 2008 09:59 | Last updated: March 25 2008 12:01Iceland’s central bank accelerated its effort to combat inflation on Tuesday by raising the main lending rate by 1.25 percentage points to 15 per cent. 

The Icelandic krona soared by more than 4 per cent against the euro after the unscheduled move by the Central Bank of Iceland.The bank said it was crucial that the depreciation of the krona – which has fallen nearly 30 per cent against the euro since the start of the year – was reversed as quickly as possible.Currency weakness has led to spiralling increases in prices, wages and the price of foreign exchange in an economy heavily reliant on the world’s debt markets.Inflation has exceeded the central bank’s 2.5 per cent target every month since April 2004 and stood at an annual rate of 6.8 per cent in February. It was expected to rise even further in March, according to analysts.“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 bank said in a statement The bank said the currency’s weakness had also made it harder for the country to finance its current account deficit.The rate rise came more than a fortnight ahead of the central bank’s planned rate meeting on April 10.In morning trading the krona was down 2.5 per cent against the euro at IKr118.52, retreating from an all-time high of IKr127.96 set last week. It fell 3 per cent against the dollar, to IKr76.39.”They were in a bit of a strange situation with the crown going completely amok in the last week, and they say that the inflation outlook is higher… [but] people probably didn’t expect a rate hike of 125 basis points,” said Elisabeth Andreew, strategist at Nordea in Copenhagen. ”It will help [the krona] in the very short term but we are quite negative still because there is so much uncertainty,” she added.Interest rates in Iceland are among the highest in the world and have led to increases in borrowing costs for the country’s highly leveraged banks and investors like Baugur, the retail investment group led by Jon Asgeir Johannesson.Baugur has bought stakes in many of the UK’s best known high street names in recent years including Debenhams, Karen Millen and House of Fraser. It is currently conducting due diligence on Moss Bros, the menswear retailer, with a view to buying the group.Iceland’s three largest banks – Kaupthing, Landsbanki and Glitnir – have seen the value of their credit default swaps or insurance against default soar in recent weeks on worries about the outlook for the Atlantic island’s economy and its reliance on the international debt markets, where borrowing rates have surged following the crisis in the banking sector.These banks grew rapidly during the credit boom, and have used the internet to tap retail investors overseas for deposits.Paul Mackel, foreign exchange strategist at HSBC, said the rate rise would not necessarily lead to a sustained rally in the krona, because the currency was very much tied to the ebb and flow of global risk appetite. “The Icelandic central bank may attempt to limit [the krona’s] weakness via higher interest rates but we know from the past that this doesn’t always work,” he said.