Board of Governors: Press Conference Thursday December 20, 2007 - an abbreviated translation of the main questions and answers

Board of Governors: Press Conference Thursday December 20, 2007 - an abbreviated translation of the main questions and answers

Question: You mentioned in your statement that the continued strength of the króna depends on foreign investors. Does this mean that we have little influence on developments as we are very small in an international context? Do foreign investors have our fate in their hands?
Chairman of the Board of Governors, Davíð Oddsson: No, I would not put it like that. We are, on the other hand, in same boat as others, i.e. events in other parts of the world are quickly felt here. The same applies to big and small in that respect. What I had in mind was among other things that large redemption dates of Glacier bonds are ahead. There were big redemptions in September that had no impact on the exchange rate of the króna at the time. Eighty billion krónur matured in September. The total amount for the month of January is roughly 60 billion krónur. The question is whether uncertainty in international markets reduces the risk appetite of international investors and whether the interest rate differential between Iceland and other countries will be sufficient for investors who wish to exploit it as they have done hitherto. This is of course all speculation but I mention it nevertheless.

Question: What role did developments in the Icelandic stock market in recent weeks and months play in the interest rate decision now?
Chairman of the Board of Governors: They make a difference and not only theses developments themselves, but also the factors underlying the developments in the stock market which to a large extent originate abroad. We have seen a strong correlation between equity prices in Iceland and in the other Nordic countries. We also know that recent developments are partly the result of the lack of liquidity in international markets and the turbulence which they have experienced. A fall in stock prices like the one we have seen can have significant wealth effects and a strong impact on expectations which are crucial in relation to underlying inflationary pressures. Recent developments have also led to more difficult financing conditions for businesses and more expensive credit and it is well known that some investors have gone relatively far in building up an equity portfolio, in some cases financed with credit. Those investors are probably squeezed at the moment. This has restraining effects.

Question: You indicated that real estate prices could fall in the time ahead. Have you assessed how large that fall could be?
Chairman of the Board of Governors: We have not made any numerical assessment of how much real estate prices might fall but they are likely to fall. I must also emphasize that it is very difficult to make predictions at the moment. What is clear is that real estate price increases have slowed down and there are stronger indications now that they may actually fall.

Question: You referred to unfavourable financial conditions. How is the Central Bank equipped to deal with difficulties in the banks if they encounter something similar to what has happened abroad, for example at Northern Rock. Can the Bank respond and stand by the banks?
Chairman of the Board of Governors: The Central Bank has a legally mandated role as a lender of last resort. That provision means that if banks that are otherwise in a sound condition, i.e. with sufficient capital but because of external conditions encounter liquidity difficulties for some reasons in the domestic market, then the Central Bank must assess the impact of such developments on general economic conditions and trust and credibility of the financial system and whether it should respond by providing liquidity against collateral. In reality it is easy for the Bank to do this domestically and there are hardly any limits to what it can do in this respect if the financial institution in question is solvent. As it happens, our banks have a strong asset base and their capital position is generally stronger than that of comparable banks in other countries, which is positive. The question that might arise is whether the problem would be a domestic one or whether the potential liquidity difficulty of a financial institution would be shortage of foreign exchange. Then the matter is somewhat different. The Bank does not give any declarations about how it might respond. In general, it would have to assess whether it would be more costly to respond or not - which alternative would be more costly for society, i.e. to respond or not to respond. Subsequently, an assessment would have to be made of its ability to respond.

Question: What is likely to have a greater impact, the policy rate or the credit squeeze at home and abroad?
Chairman of the Board of Governors: We are first and foremost pursuing price stability. We have been unable to achieve the inflation target for some time. I think that all reasonable people would agree that the monetary restraint applied by the Bank has meant that inflation has not gone out of control although underlying pressures have been very strong. Of course the Bank is not content to have to apply very high policy rates and a large interest rate differential between Iceland and other countries, but our task is to keep inflation under control. The current conditions in the markets are such, as we mentioned in our policy statement, that they have an impact on the aggregates which we monitor and weigh into our decisions. They reduce inflationary and demand pressures.

Governor Ingimundur Friðriksson: We also draw your attention to the fact that for a long while, increasing monetary restrained had little impact on interest rates at the long end of the market. That has changed this year, particularly after the last police rate hike. Indexed interest rates have risen sharply this year and this will have a restraining impact.

Question: You mentioned earlier the possibility of more unfavourable exchange rate and wage developments than envisaged in the base forecast published last month. Wage negotiations are currently under way. Is the Bank sending a message to the wage negotiating partners to stay within reasonable bounds and what are the bounds in the Central Bank’s assessment?
Chairman of the Board of Governors: The Central Bank is not sending any messages to the wage negotiators. The Bank is nevertheless aware, as everyone else, that when wages are negotiated under conditions of relatively high inflation, then that creates a tendency to compensate for inflation, even with potential chain reactions. The Bank only says that this is a difficult task under present conditions and it draws the attention to the fact that if the results of the wage round are such that inflation rises again, then the task of the Central Bank is very clear. In the same vane, the Bank refers to the exchange rate. If exchange rate developments turn out to be more unfavourable than foreseen at the moment, then such developments could mean that the Bank deviates from the policy rate path that it has published.

Question: It was mentioned in my newspaper a few days ago that unchanged policy rate here in the light of lower policy rates in the US and the UK meant in reality a policy rate hike here. Do you agree?
Chairman of the Board of Governors: It is clear that the interest rate differential has been rising against those countries where policy rates have been falling. Policy rates have been lowered in the US and the UK. In US it is a problem because at the same time as there are difficulties in the markets, underlying inflationary pressures seem to be on the rise so the Federal Reserve faces a challenge. The objectives of the Federal Reserve and its framework are somewhat different from ours and those of many other central banks. Nevertheless, the Federal Reserve has obligations and objectives where price stability figures very importantly. Other central banks, like the ECB, kept its rate unchanged and in a press conference announcing its latest decision, it was mentioned that discussions in the Governing Council had centered around unchanged or higher rates so developments are not necessarily the same everywhere. The Bank of Norway raised its rates a few days ago. Many have hoped that the current difficulties in markets would somehow disappear over night. Many are looking to the turn of the year and hopefully they are right. However, the prospects for quick improvement are not good at the moment. Many have referred to the current difficulties as superficial because they stem from a general lack of trust among banks. If that lack of confidence or trust were somehow to disappear, then the problems would be solved. Many factors point in another direction at the international level, i.e. that the problems are turning into more lasting ones, that large asset losses will lead to bankruptcies and difficult conditions for many companies and financial institutions. If that happens, then it is more likely that the current global difficulties will last well into next year and I think we should be prepared for that. If that does not happen, then we will surely welcome the good news.

Question: Can one say that in the current circumstances, an unchanged policy rate is equivalent to a policy rate hike?
Chairman of the Board of Governors: Some may look at it that way but I don’t think we should read much into that.

Chief Economist Arnór Sighvatsson: I would perhaps phrase this such that since the Central Bank raised its policy rate the last time, financial conditions have worsened even though the policy rate has not risen further. That is not the same as saying that an unchanged policy rate is equivalent to an interest rate hike.

Question: In the current circumstances, would it be advisable to change the indexation of financial obligations in any manner, for example to abolish it as some have suggested?
Chairman of the Board of Governors: I don’t think it is wise to change much in this respect at the moment. If one wants to look at indexation it is better to do that when conditions are more tranquil and the end result is not clear, there are costs and benefits to be weighed against each other.

Question: Does the decision not to raise rates today mean that you are more concerned about financial stability than price stability?
Chairman of the Board of Governors: No, our statement should not be interpreted like that. Even tough some factors have led to a higher rate of inflation in the last two months than we had expected and forecast, many other factors weigh against these inflationary developments and we look to them. There is little doubt that we are near a turning point in the economy although we do not yet have statistics to confirm that. There are various signs that this could be the case and in these conditions it is advisable to have an opportunity to assess conditions more thoroughly and look to the future and that we will be able to do before the next interest rate decision on February 14, 2008.

Question: Do you exclude the possibility of further interest rate rises?
Chairman of the Board of Governors: No. As referred to in the final paragraph of the policy statement of today, if certain factors move in an unfavorable direction or become different from what we expect and hope, then the Bank must respond and one can envisage what the response would be.