REYKJAVIK, July 3, 2008 (AFP) - The Icelandic central bank held its key interest rate at 15.5 percent, one of the industrialised world's highest rates, on Thursday.

'The board of governors of the Central Bank of Iceland has decided to hold the Bank's policy interest rate unchanged at 15.5 percent,' said the Sedlabanki, which also left its key rate unchanged following a meeting in May.

Thursday's decision came as both the European Central Bank and the Swedish central bank raised their main interest rates in an attempt to curb inflation.

Icelandic inflation also 'rose sharply in the wake of the depreciation of the krona during the first months of the year and is now higher than the bank forecast in April,' the Sedlabanki said in a statement.

The Nordic island's annual inflation rate in June rose to 12.7 percent from 12.3 percent in May, as the krona continued to crumble.

The Icelandic currency has lost 26.9 percent of its value since the beginning of the year.

Iceland is one of the most prosperous nations in the 30-member Organisation for Economic Cooperation and Development. In recent years, its economy has grown on average by 4.0 percent per year.

But the economy has overheated and in 2007 its gross domestic production grew just 3.8 percent while its annual inflation rate stood at 5.7 percent, more than twice the target ceiling of 2.5 percent set by the Icelandic central bank.

'Inflation will remain high into next year but decline rapidly thereafter,' the bank said.

It said it also expected 'considerable contraction' in the country's GDP over the next two years, following a period prolonged growth.

'That growth was not always sustainable as is confirmed by the current account deficit. A contraction is therefore inevitable if equilibrium is to be restored,' the Sedlabanki said.

'Dwindling economic activity will better enable the Central Bank to contain inflation, however, the contraction will be a burden for many, particularly those who are most indebted,' it added.

The bank revised down its outlook for economic growth this year to 1.1 percent from 2.2 percent, but said it expected GDP to shrink by only 2.0 percent next year, compared to its previous forecast of a 2.5 percent decline.

It also said inflation was expected to be 11.3 percent this year and 7.6 percent next year, up from a previous estimate of 9.3 percent and 5.9 percent respectively.

The bank's next rate decision is scheduled for September 11.