UPDATE 2-Iceland keeps rates unchanged, outlook uncertain

Wed Mar 16, 2011 7:53am EDT

Related Topics

* Key rate unchanged 4.25 pct as expected

* Rate path uncertain due to debt dispute, capital controls

* Rates have fallen over more than two years from 18 pct

* Analysts say rates have most likely bottomed out

(Adds detail, background)

By Omar Valdimarsson

REYKJAVIK, March 16 (Reuters) - Iceland's central bank left its key interest rate unchanged on Wednesday and said the direction of future policy moves is uncertain pending a loosening of capital controls and a key vote on debt repayment.

As part of Iceland's slow reintegration to the world economy, the government aims to publish a blueprint by March 25 for easing capital controls imposed in 2008 when the global debt crisis brought down the island's over-extended banks. [ID:nLDE72A0NP]

However, major moves are likely to be deferred until after Iceland's April 9 referendum, aimed at ending a dispute with Britain and the Netherlands over $5 billion in debts incurred on high interest savings accounts when Icelandic bank Landsbanki went under. [ID:nLDE71M1GP]

"The uncertainty stemming from the pending Icesave referendum and the fact that the capital account liberalisation strategy has not been finalised calls for extra caution at the current juncture," the central bank, Sedlabanki, said in a statement.

The central bank left its key seven-day collateralised lending rate, which has fallen from a peak of 18 percent over two years, at 4.25 percent, in line with analysts' expectations.

SEB strategist Mats Lindh said the rate has most likely reached bottom and will stay flat for some time, although further cuts cannot be ruled out in view of a fragile economic recovery.

"It will be easier to predict the rate path after the government has unveiled their capital control plans. But the central bank will start raising only once the economy has gained pace, in a couple of quarters' time at the earliest," he said.

Preliminary data showed last week the economy shrank in the fourth quarter from the third, and inched up only marginally compared with a year earlier. [ID:nLDE7270MU]

Sedlabanki said on Wednesday the data suggests somewhat weaker economic activity than previously expected.

It expects inflation to stay below its 2.5 percent target in coming months and to approach the target over the medium term.

"With the prospect that inflation will remain near target and with interest rates at a historically low level, the direction of future policy moves remains uncertain," it said.

"In addition, the prospect of removing the capital controls creates uncertainty about short-term room for manoeuvre."

Danske Bank analyst Lars Christiansen said there is probably some room to tighten monetary policy but the rate will be kept unchanged in the near future, at a significantly higher level than most European economies, to support the Icelandic crown.

"We, have seen the first signs of recovery in the Icelandic economy. Sedlabanki also wants to keep some carry relative to the rest of Europe and the United States when we move forward towards liberalisation of capital controls."

Analysts expect Iceland to wind up the capital controls over the coming years.

For stories on Icelandic interest rates, click on [ISCBIR=ECI]

(Additional reporting by Anna Ringstrom and Johan Ahlander in Stockholm; Editing by Toby Chopra/Ruth Pitchford)

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