Simon Johnson

Iceland's central bank signaled on Wednesday that interest rates may have bottomed out as it cut borrowing costs by 25 basis points to support a slow recovery from a brutal downturn.

Iceland's economy came close to collapse in late 2008 when all the country's main banks were taken over by the government within the space of a week, as they were no longer able to raise funds.

The economy contracted 6.8 percent in 2009, but the picture has slowly been improving since, thanks in part to aid from the International Monetary Fund (IMF) and European neighbors.

Inflation has come down, the crown currency has stabilized and interest rates have fallen from a peak of 18 percent over the last two years with the key seven-day collateralized lending now at 4.25 percent after Wednesday's decision.

However, the central bank may not be able to cut rates much further if the country wants to remove capital controls, put in place to shield the crown at the height of the crisis.

The crown, which has weakened sharply against the euro so far this year on uncertainty about the economic outlook, showed little reaction to the rate cut, which was expected.

The central bank said removal of capital controls would probably happen within the bank's forecast horizon, which runs through 2013.

I think the MPC (central bank Monetary Policy Committee) is actually preparing for the beginning of the removal of capital controls before the beginning of 2013, so they are afraid of cutting rates too deeply, said SEB strategist Mats Lindh.

I would take it as a signal that this cut is the last.

Analysts had expected a cut of between 25 and 75 basis points.

With the prospect that inflation will remain near target and with interest rates at a historically low level, the direction of future policy moves becomes more uncertain, the central bank said in a statement.

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

ECONOMIC RECOVERY

The central bank said that after an expected 2.7 percent contraction in GDP last year, the economy would pick up again this year.

It forecast output growth of 2.8 percent in 2011 and more than 3 percent in 2012 and 2013.

While growth is returning, the country has yet to return to financial normality.

It has inked a preliminary deal with Britain and the Netherlands over debts from the collapse of Landsbanki's Icesave online accounts. Parliament, which will start to debate the deal on Wednesday, must approve the agreement.

And the country is eyeing its first international bond issue.

However, capital controls, adopted at the height of the crisis, are still in place, giving the central bank a headache in matching the need to boost growth at home without undermining support for the Icelandic crown when controls are removed.

The IMF said in January that Iceland should be cautious in removing capital controls until it is clear that conditions are suitable.

The government is preparing a strategy for removing capital controls which it expects to adopt by the end of February.

(Editing by John Stonestreet and Susan Fenton)

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