Iceland Delivers Surprise Rate Cut Weeks Before Snap Election

(Bloomberg) -- Iceland's central bank delivered a surprise rate cut just weeks before the island is due to hold a snap election that could alter the political and economic policy landscape.

The bank lowered its seven-day term deposit rate to 4.25 percent from 4.50 percent, it said on Wednesday. With the krona forecast to start appreciating, analysts had expected rates to be unchanged.

The bank said it decided to cut rates in response to deteriorating economic prospects. “The outlook is for weaker economic growth this year than last year, partly because of the slowdown in tourism,” it said.

To be sure, Iceland's economy is still growing faster than much of the rest of Europe. Moody's Investors Service is forecasting economic growth of 3.5 percent this year, down from last year's galloping pace of 7.4 percent.

Meanwhile the political outlook is uncertain. Iceland will hold a snap election on Oct. 28 after the resignation of Prime Minister Bjarni Benediktsson over a scandal involving his father. Capital Economics predicts that a victory by center-left parties would likely lead to an expansionary fiscal policy and earlier rate hikes than anticipated.

Read more: Iceland PM Calls Snap Vote as Pedophile Furor Crashes Coalition

In a nod to the potential for policy to change direction, the central bank signaled there was also the possibility of higher rates. “The tension in the economy calls for monetary tightening to ensure price stability over the medium term,” it said.

“The monetary stance of the coming months will depend on the economic and other economic developments,” it said.

Headline inflation came in at an annual 1.4 percent in September, slowing from 1.7 percent in August and well below the central bank's 2.5 percent target. But adjusting for housing costs, the island would in fact be experiencing deflation, with prices falling around 3 percent, according to Iceland's statistics agency.

To contact the reporter on this story: Nick Rigillo in Copenhagen at nrigillo@bloomberg.net.

To contact the editors responsible for this story: Jonas Bergman at jbergman@bloomberg.net, Tasneem Hanfi Brögger