By Natsuko Waki
BASEL, Switzerland, June 28 (Reuters) - Iceland's economic recovery is unlikely to start until the third quarter and the central bank could cut interest rates again, its governor said on Monday.
The North Atlantic island has been picking up the pieces of its shattered economy following the collapse of its financial system and currency in late 2008. The economy grew 0.6 percent in the first quarter from the previous three months.
"We at the central bank don't think the recovery has started yet and we're more expecting the recovery to start in the Q3," Mar Gudmundsson told Reuters in an interview.
"However, the economy does not seem to be contracting and seems to be more like on a plateau. We're not confident about declaring the recovery yet."
The central bank cut its key rate to 8.0 percent last week after taking borrowing costs to a record high of 18 percent and imposed strict capital controls to protect its currency.
The crisis also forced the country to take a $10 billion bailout from the International Monetary Fund and Nordic states, and it remains in dispute over funds to repay depositors in failed Icelandic banks in Britain and the Netherlands.
"When we set interest rates in the months to come, what we will be looking at is what has happened to the exchange rate and inflation, but we will also take into account the possible near-term prospects of lifting capital controls on outflows," he said.
"We've committed not to lift capital controls on outflows until after the third review of the IMF which hopefully will take place early in the autumn. We're keeping interest rates somewhat higher than otherwise. That doesn't mean we cannot cut."
The central bank's next meeting is on Aug. 18.
Inflation was 7.5 percent year-on-year in May. Gudmundsson said inflation adjusted for effects from tax increases was lower at 6.1 percent and this could more than halve into next year.
"We're expecting our inflation to reach our target (of 2.5 percent) very early next year if we exclude tax effects," he said.
The Icelandic crown hit a 15-month high near 155 per euro
"In the medium term we see the krona appreciating further. It's undervalued when taking into account its historical level and fundamentals like the debt position. 157 (per euro) is still low in historical terms," he said.
(Editing by Toby Chopra)