Speech by Eiríkur Guðnason, Governor of the Central Bank of Iceland
I thank you for this opportunity to discuss the monetary situation and outlook. The Central Bank has recently published the third issue this year of its quarterly Monetary Bulletin. Those of you who have read it will recognise much of what I am about say.
Very clear objectives are set out in the Central Bank Act. The main objective is to promote price stability. Arrangements for doing so are described in more detail in the joint declaration of the Government of Iceland and the Central Bank from March 2001. Another important objective is to promote an efficient and safe financial system, i.e. to have an overview of the strength of the financial institutions operating in
The target of monetary policy is to keep twelve-month inflation, as measured by the consumer price index, as close to 2½% on average as possible. It should be underlined that the target involves not only keeping inflation within the tolerance limits (1-4%) but as close as possible to 2½%. The Central Bank is obliged to make its assessment of the current economic situation and outlook public, including publication of a forecast for inflation two years ahead. Under the Central Bank of Act of 2001, the Bank was granted full independence to use its instruments, i.e. to determine its own rate of interest without consultation with the government. Since the effect of changes in central bank interest rates are transmitted through the economy with a considerable lag, interest-rate decisions need to be forward-looking. Central bank interest-rate decisions often affect short-term interest rates quickly, but a much longer lag can occur before their impact is felt in the long-term market, which can in fact take various forms. This all depends on expectations, which play a vital role in financial markets.
It is now four and a half years since
When it was decided to build an aluminium smelter and hydropower station in east
Two main factors have contributed to the economic imbalances which now prevail in the economy and are highlighted by the wide current account deficit and inflation beyond the target. First, investments in the aluminium and power sectors turned out far greater than was originally expected, because on top of the east
The second driver of macroeconomic imbalances has been the sweeping change that took place in the mortgage loan market in the second half of 2004 when the commercial banks and savings banks began providing mortgages on completely different terms from those previously offered. In a report compiled at the request of the Minister for Social Affairs and published on the Central Bank’s website towards the end of last year, the Bank pointed out the problems that could accompany higher loan-to-value ratios and maximum mortgage amounts from the Housing Financing Fund. When plans for such increased credit were announced together with lower mortgage interest rates, the commercial banks and savings banks entered this field with full force and have provided new mortgage loans which are now rapidly approaching 300 b.kr. The impact of this completely unforeseen development was felt too soon to leave any scope for timely monetary policy responses. A considerable share of the new borrowing has been used to prepay old loans on less favourable terms from both the Housing Financing Fund and the pension funds. However, it is obvious that households have also used some of their borrowing to fund private consumption, as reflected in heavy levels of imports and the wide current account deficit. In the Central Bank’s view, the commercial banks and savings banks have overstepped the mark in this respect. Of course, it is to be welcomed that competition in financial markets will benefit households in the long run, and also that lending secured against real estate consolidates the financial foundations of the banks, as both international ratings agencies and the IMF have pointed out. Nonetheless, the timing of the change was very unfortunate.
There are grounds for urging the credit institutions to show caution in their lending decisions and pay close attention to the security of their loans. The Central Bank has repeatedly pointed out the need to consider the future role of the Housing Financing Fund in mortgage financing and the possible division of tasks between the fund and the commercial banks and savings banks, to consolidate both the domestic financial system and facilities for those who for various reasons do not have normal access to mortgage finance. Last but not least, households must be urged to pay close attention to their finances and take care not to assume liabilities that could prove problematic later on.
Interest rate changes
According to the Central Bank’s analysis, macroeconomic imbalances are now much more pronounced than was assumed at the beginning of June when the second issue of Monetary Bulletin for this year was published. The Central Bank announced its economic assessment a fortnight ago and raised its policy interest rate by 0.75 percentage points at the same time. The policy interest rate has been raised by almost 5 percentage points since May 2004. This has provoked discussion in the media, the banks’ research departments and elsewhere. I would like to mention several points that have been raised in the past few days. At the Central Bank, we welcome discussion of monetary issues and criticism of our policies and methods. In fact I feel that this debate has become much more sophisticated in recent years, not least thanks to the banks’ research departments. However, we sometimes detect certain misunderstandings.
Issues of króna-denominated bonds in international markets
The Central Bank’s policy rate hikes have inevitably caused the interest-rate differential between
Divergent assessments by Central Bank and Ministry of Finance
It has been pointed out that it is inappropriate for the Central Bank and the Ministry of Finance to produce different assessments of the economic outlook. The Central Bank’s latest forecast implied somewhat more near-term growth in private consumption and more robust economic growth than in the Ministry’s figures. It could be asked whether these two bodies should agree on a single forecast. I think that this would be very inadvisable and I expect that the ministry’s experts would agree. The Central Bank’s independence would be severely diminished if it did not assess the position and outlook using what it considers to be the most accurate assumptions at any given time. Forecasting methods may differ, and likewise the underlying assumptions. For example, the Central Bank and the ministry do not make the same assumptions for changes in interest rates and the exchange rate in their respective forecasts. So it is no surprise to see different outcomes. On the other hand, all forecasters are eager to improve their methodologies as far as they can and learn from each other. Thus it is natural, once the Central Bank and Ministry of Finance have presented their forecasts, for their experts to compare them and examine them in depth, in the interest of mutual understanding. Such communication does take place and is conducive to improved forecasting.
Did monetary policy go on holiday for the summer?
The Central Bank has been criticised for the current high level of interest rates. Claims have also been heard that it should have raised the policy rate earlier and by more than it has done recently. One criticism was that the Bank allowed too long an interval between its last two interest-rate adjustments, which were announced on June 3 and September 29. One research department advised that monetary policy should not go on holiday for the summer. I assure you that monetary policy did not go on holiday for the summer. As it does in all the other months, the Central Bank pondered during the summer whether it needed to adjust the interest rate. The decision not to do so may seem strange in light of the fairly large hike at the end of September. The explanation is that the outlook had changed substantially after Statistics Iceland released new national accounts data and a new inflation forecast had been produced. The day before yesterday, Statistics Iceland published the CPI for October which showed a 4.6% increase year-on-year. Recent index measurements show unmistakable signs of intense domestic demand. This is reflected in rising prices for goods and services that are shielded from foreign competition, and in the fact that only part of the appreciation of the króna in recent months is being transmitted to prices of imported goods. Prices of motor vehicles are a particular case in point. Unexpectedly robust demand almost certainly plays a major part in this adverse development.
Frequency of interest-rate decisions
In recent discussions the Central Bank has sometimes been called upon to follow the lead of other inflation-targeting central banks and give advance notice of meetings at which interest rates are set. The Central Bank of
Ideas have been raised for increased Central Bank purchases of foreign currency, with two aims: to boost
Should price-indexation of financial obligations be eased?
It has been claimed that the extensive use of price-indexation of capital in
Would it be appropriate to adopt the euro?
Some people advocate that
Over the next few years, macroeconomic conditions will be exceptionally difficult from a monetary policy point of view. In fact they will serve as a test for how suitable the current policy is for a small, open economy. In the Central Bank’s view, it is vital for monetary policy to pass this test and prevent all but the very briefest large deviations from the inflation target. The Central Bank is obliged to work towards this end and to do so it has only one instrument, the policy interest rate. The Central Bank is absolutely serious in keeping inflation as close as possible to the target over the next two years and further ahead, even if this temporarily hits certain sectors hard. The present unique climate presents a challenge to monetary policy implementation and has certain undesirable impacts on its effectiveness. The tightened stance at the moment has very disparate effects on different sectors: it hits exporters hard but as yet has left households relatively unscathed. In such a climate, we should be wary of imaging that there are simple solutions for easing the position of, say, the export sectors. It has been claimed that inflation should be “let through” to help export industries. Such ideas should be treated with circumspection. If inflation were “let through”, which would be achieved by easing the monetary stance, the real exchange rate of the króna would appreciate due to higher inflation in Iceland than abroad, wage-earners would press for higher wages than otherwise and the economy would be left not only with a high real exchange rate but also high inflation – with accompanying disruptions to business operating conditions and financial troubles for indebted households. Moreover, even tougher measures would eventually be needed to drive down inflation than those that are currently needed to keep it in check.
Inflation has measured some way above the target on average since it was adopted. The Central Bank therefore faces a considerable challenge in building confidence in its monetary policy, but is determined to do so. Credibility has to be earned the hard way. By supporting the Central Bank in its efforts, the public sector, the banks and other parts of the private sector can help to rein in inflation and reduce the side-effects in the process. Whether the Bank receives such support or not, it will not flinch from its goal to attain the inflation target over the medium run. In the long run, businesses and households alike will reap the benefits.
* See Central Bank of