* C.bank cuts key rate to 4.25 pct from 4.50 pct
* Analysts had seen cut of 25-75 bps
* Direction of policy now less certain
* Rates have fallen over two years from around 18 pct
(Adds c.bank governor comment)
Simon Johnson
STOCKHOLM, Feb 2 (Reuters) - Iceland's central bank signalled on Wednesday that interest rates are close to bottoming out after nearly two years of monetary easing as the crisis-hit island aims at eventually easing currency controls.
The currency controls were imposed in late 2008 to stop the crown sliding further after the economy came close to collapse when the heavily-indebted top three banks were taken over by the state within a week.
"We are getting much closer to what might be considered to be some kind of equilibrium rate, even taking into account the slack in the economy," central bank Governor Mar Gudmundsson told Reuters after the bank shaved 25 basis points off rates.
"We are not necessarily saying that we have reached the end, we are saying that the next move is more uncertain."
The rate cut on Wednesday took the key seven-day collateralised lending to 4.25 percent from 4.5 percent, down from a peak of 18 percent over the last two years.
The bank said in a statement that the direction of future policy moves was uncertain as rates were at historic lows. The prospect of removing the capital controls "creates uncertainty about short-term room for manoeuvre", it added.
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 neighbours.
"The big news ... is not that the rate cut was smaller than expected, but the MPC's statement implies that the monetary easing that has been underway since the beginning of 2009 may be at an end," Icelandic bank Islandsbanki said in a research note.
"It appears that the Committee is afraid of further ISK depreciation."
SEB strategist Mats Lindh said the cut was set to be the last. "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," he said.
ENDING CONTROLS TO TAKE TIME
Gudmundsson said some limited moves to remove capital controls could come within the next six months, but that lifting all controls would take longer.
"We will start within that time frame, but how far we will go is very much uncertain at this point," he said.
The central bank will present the government with its advice on how to proceed at the end of February.
Gudmundsson said Iceland needed to meet certain conditions before it could act, including macroeconomic stability, sufficient foreign currency reserves and strong banks.
"We need the financial sector to be strong enough to withstand ... the free movement of capital and that is where the jury is still out," he said.
The crown
The bank said that after an expected 2.7 percent contraction in GDP last year, the economy would pick up again this year to 2.8 percent growth and more than 3 percent in 2012 and 2013.
For stories on Icelandic interest rates, click on [ISCBIR=ECI] (Editing by Ron Askew)