The capital controls imposed during the 2009 global financial crisis have been gradually removed in recent years and were almost fully lifted in March 2019 (with only three minor exceptions). This should facilitate currency flows in and out of the country, though it may also lead to somewhat higher exchange rate volatility. After markedly appreciating during the boom years of 2015-2017, the Icelandic krona (ISK) depreciated by an average -6% against the EUR in 2018. In the first half of 2019, the currency lost another -6% in value, though it recovered half of that in the subsequent two months. The losses since the start of 2018, as well as the increased volatility, can largely be explained by the weakening tourism sector and the substantial lifting of capital controls in 2017.

Monetary policy is focused on maintaining price stability, but the Central Bank of Iceland (CBI) also intervenes in foreign exchange (FX) markets to limit the short-term volatility of the ISK, if deemed appropriate. Current FX reserves of USD6.7bn (June 2019) provide for ample policy buffers. As a result of the ISK depreciation since 2018, annual consumer price inflation picked up from 1.9% at end-2017 to a temporary peak of 3.7% at end-2018, well exceeding the CBI’s 2.5% inflation target, before easing somewhat to 3.1% in July 2019. Consequently, the CBI raised its key policy interest rate by 25bp to 4.5% in November 2018. But as the economy has been slowing and inflation retreating in H1 2019, the CBI lowered its policy rate again by 75bp in two steps to 3.75% in June. We forecast inflation to moderate further to about 3% at end-2019 and 2.5% at end-2020. The CBI is likely to cut rates one more time in 2019 but will remain prudent overall.

Fiscal policy is firmly commit­ted to debt reduction. Annual fiscal surpluses have been recorded since 2016 and public debt has rapidly decreased from a peak of 92% of GDP in 2011. As GDP growth will stall in 2019, the fiscal surplus is expected to narrow to just over 0% of GDP, while public debt in relation to GDP is forecast to level off at about 36%, a modest ratio compared to the EU average, for example.