STOCKHOLM, Aug 11 (Reuters) - Iceland should focus on improving its currency regime in case the island remained a euro outsider for some time, the central bank said on Tuesday, adding the government must also avoid raising its inflation target.
The central bank, in a summary of an analysis of Iceland's monetary policy framework, said the government needed to give "serious consideration" to improving the current system.
That was because of all the uncertainties over Iceland joining the European Union or ultimately adopting the euro, and the time it would take to develop a new currency regime. It did not elaborate on what detailed improvements should be made.
Regarding any suggestion Iceland should lift its inflation target given the inability to achieve the current 2.5 percent goal, the report said this would be a mistake: It would raise inflation expectations and long-term lending rates.
"The main risk is that such a change would undermine the credibility of both monetary policy and the inflation target for the long term," Sedlabanki said.
"It would also convey the message that the inflation target could always be changed in difficult times, whenever it proved difficult to attain."
Sedlabanki said these were preliminary findings and a final report would be finished by the end of the coming winter season.
In July, Iceland's consumer price index rose at an annual pace of 11.3 percent, far above the 2.5 percent target.
Iceland applied last month to join the EU, but any decision would require a national referendum.
In the mean time, a return to the former fixed exchange rate policy seems far-fetched in light of the lifting of the current capital account restrictions, the central bank said.
In absence of a new regime, the central bank would need stronger tools to enable it to rein in growth in the financial system, the report said.
Also, the fiscal policy framework should be improved "so that it provides better support for monetary policy, thus reducing the likelihood of volatile capital inflows and economic instability".
(Reporting by Veronica Ek)