Icelandic Stagflation

In a bid to stabilize its currency, which is down 70% this year, Iceland raised its interest rate from 12% to 18%, after having cut it from 15.5% just a few weeks earlier. To the extent it succeeds, it might actually strengthen the economy, as the excessive weakness of the krona is the key problem facing the Icelandic economy. Not only does it contribute to a sharp increase in inflation, but by increasing the domestic currency value of its foreign debt, it makes the problem of too much debt even worse. However, in these times of extreme risk aversion from investors, it can be questioned just how effective it will be. Moreover, given the extremely high level of inflation in Iceland, 18% isn't exactly high.

To get a perspective on how bad things are in Iceland, the forecasts in this Bloomberg report are useful.

"The central bank is raising rates as Iceland, the first western nation to seek financial help from the IMF since the U.K. in 1976, faces an economic contraction, coupled with possible hyperinflation and rising joblessness. The economy will shrink as much as 10 percent next year, the IMF forecasts. Iceland will receive about $2.1 billion from the Washington-based fund, according to a deal struck on Oct. 24....

....The increase in the key rate comes after the central bank on Oct. 15 cut it by 3.5 percentage points from 15.5 percent. That move indicated policy makers were focusing on growth and abandoning their target of stabilizing inflation, which may soar as high as 75 percent in coming months, according to Lars Christensen, chief analyst at Danske Bank A/S in Copenhagen."

And I personally think that a 10% contraction is probably on the optimistic side.