When it was decided to raise the policy rate on December 21, it was known that inflation had slowed down to considerably below the midyear forecast rate. Inflation was mainly brought down by lower energy prices, the impact of the appreciation of the króna since the middle of the year, less-thanexpected wage drift and a slowdown in house price inflation. Domestic demand in Q3 was broadly in line with the Central Bank’s November forecast. It was also known that the current account deficit was wider than expected in Q3 and would significantly overshoot the forecast for the year as a whole. No indications of easing labour market pressures could be seen. Unemployment was negligible and there was a large influx of foreign labour. Despite lower inflation than in the Bank’s July forecast, there was still no sign that the target would be attained within two years if the effect of indirect tax cuts on headline CPI in the first half of 2007 was ignored. Furthermore, the wide current account deficit and tight labour market aroused suspicions that pressures in the economy were underestimated, and thereby inflationary pressures as well. As mentioned earlier, policy rate hikes primarily impact the exchange rate. The króna appreciated substantially until near the end of 2005. By then it was considerably stronger than was compatible with external balance in the economy, as the Central Bank had explained in detail, among other things in its December Monetary Bulletin that year. So it was not surprising that the króna depreciated.
As I mentioned earlier, the Central Bank left its policy rate unchanged on the last interest rate decision date, February 8. In December it raised the rate to 14.25%. This was the eighteenth hike since May 2004; prior to that, the policy rate had been held at 5.3% for more than a year. The Central Bank noted that its December hike seemed to come as a surprise. The introduction to Monetary Bulletin, which was published on November 2, stated that a reduction in the policy interest rate was still not in sight, in spite of substantially brighter inflation prospects. On the contrary, it was impossible to rule out a further policy rate hike in order to attain the inflation target within an acceptable timeframe, and the analysis presented then implied that there were still grounds for tightening the monetary stance further. However, the Board of Governors had decided to postpone such a measure for the time being. The next interest rate decision, to be announced on December 21, 2006, would be based on the analysis in the November Monetary Bulletin and additional data that became available by that time. The Chairman of the Board of Governors underlined this message from Monetary Bulletin in a speech a few days later when he described the decision to leave the policy rate unchanged on November 2 as a deferral of an increase rather than the end of the tightening of the stance.