11.09.2008

Monetary policy statement by the Board of Governors of the Central Bank of Iceland: Policy rate remains unchanged

The Board of Governors of the Central Bank of Iceland has decided to leave the Bank's policy interest rate unchanged at 15.5%.

Economic indicators are divergent at present. Inflation rose sharply in the wake of the depreciation of the króna during the first months of the year, however, it remains likely that inflation is near its peak and will unwind quickly over the coming year. The króna is weaker than was projected in July, and the real exchange rate is at a historical low. Furthermore, recent figures indicate stronger output growth than previously forecast, which suggests that the disinflation process could be somewhat slower than assumed in July. In addition, the real policy rate has declined in recent months, as a result of increased inflation and higher inflation expectations. Several factors offset this, however: consumer sentiment indices have declined sharply, access to credit has tightened, and high interest spreads complement restrictive monetary policy.

The national accounts published this morning show that, in spite of a contraction in private consumption, GDP growth was considerable in the second quarter of 2008, due in particular to growth in exports. Output growth in 2007 and Q1/2008 was also stronger than previous estimates indicated. While it would be imprudent to draw broad-based conclusions from statistics for a single quarter, it is noteworthy that these statistics concur with known indicators. The labour market survey for Q2 reveals robust employment growth year-on-year, and unemployment is hardly discernible in spite of a rise in redundancies.

The Central Bank considers it likely that GDP will contract over the next two years despite the unexpected vigour in the economy this year. A contraction is an inevitable element in the economy's adjustment towards a sustainable equilibrium following a period of very strong growth, and it will help the Central Bank to reign in inflation. Adopting stimulative measures under the current conditions - by relaxing monetary or fiscal policy - would be inappropriate and ill-timed. Such measures would undoubtedly delay the adjustment of the economy, weaken the króna, promote higher inflation, and raise inflation expectations. Such a policy will ultimately lead to an even sharper economic contraction. It will weaken the balance sheets of indebted households and businesses and undermine financial stability. It is vital that fiscal policy supports monetary policy in reducing inflation and contributing to internal and external balance in the economy.
In the recent term, the Central Bank and the Government have worked together to bolster confidence in the financial system and enhance financial market functioning. Swap agreements have been concluded with Nordic central banks, certificates of deposit have been issued, Treasury note issuance has been expanded, and the foreign exchange reserves have been strengthened substantially. The global credit markets are in a deep slump, and risk premia are high in general as a result of the prevailing lack of confidence. It is inadvisable and pointless for a debt-free Treasury to accept unreasonable terms under unusual market conditions; therefore, the Central Bank has strengthened its foreign exchange reserves in prudent increments. Furthermore, the Bank has amended its rules on collateralised lending to financial undertakings so as to align them with those of the European Central Bank. The Central Bank of Iceland will continue to reinforce the infrastructure of the financial system.
It is necessary to keep the policy rate high until inflation and inflation expectations have begun to move decisively toward the inflation target. To vacillate now would be worse for all in the short and long term. Monetary policy must provide the restraint that is necessary to reduce inflation and inflation expectations. Spiralling wages, prices, and exchange rates are a known driver of inflation in Iceland. If the public and private sectors make a commitment to support the Central Bank in its efforts to control inflation, that effort will expedite the reduction of the policy rate and the recovery of the economy and will bolster disposable income for the long term.


No. 26/2008
September 11, 2008

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