Statement of the Central Bank of Iceland Monetary Policy Committee: Cautious easing of monetary policy is now appropriate

The Monetary Policy Committee (MPC) of the Central Bank of Iceland has voted to lower its policy rate by one percentage point to 17 percent. Economic indicators suggest that conditions for easing are in place. Inflationary pressures have subsided as demand and employment contract and the króna has stabilised. The flexibility of the Icelandic economy has enabled a rapid adjustment of domestic demand, real wages and the trade balance. A large trade deficit has turned to a significant surplus.

The fragility of the balance sheets of businesses, households and banks calls for the stability of the króna. This implies the need for a tighter monetary policy than would be appropriate otherwise.

Over the next few months important steps will be taken in the restructuring and reestablishment of the Icelandic financial system. Once the financial sector restructuring is completed, the overall external and public debt situation and fiscal adjustment is clarified and financial markets become more functional, the ability of monetary policy to support economic recovery over the medium term will be enhanced.

After a one-off adjustment following the depreciation of the króna through 2008, inflation appears to have peaked in January and seems to be declining faster than previously forecast. The outlook is for Q1 inflation to be significantly below the end-January forecast of 18.5 percent and for inflation to return to the 2.5 percent target by early next year. This is supported by the growing slack in the economy as indicated by national accounts data, higher unemployment and other short-term indicators. A weak labour market greatly reduces the risk of second-round effects.

Current monetary policy is guided by the interim objective of stabilising the exchange rate, while the long-term goal remains the inflation target. This is primarily because of the need to protect vulnerable private sector balance sheets during the restructuring phase.

Capital controls support this goal by preventing disorderly capital outflows and protecting foreign currency reserves. These controls will remain in place until it is deemed to be safe to lift them. Considerable uncertainty remains concerning external debt, government financing and financial sector restructuring, and the global environment remains difficult. The preconditions for lifting the capital controls are therefore not yet in place.

Monetary policy decisions are taken with a view towards the eventual abolition of capital controls. Thus, ISK-denominated assets need to continue to offer sufficiently favourable risk-adjusted yields. However, it should be noted that short-term interest rates in the rest of the world have declined significantly since the last monetary policy decision, increasing the interest rate differential between the króna and other currencies, and it appears likely that some easing of monetary policy will not put the stability of the króna at risk. The MPC must proceed with care as it embarks upon a path of monetary easing, with adjustments reflecting improvements in economic stability. In this light, the MPC has scheduled an additional rate-setting meeting and monetary policy announcement for 8 April 2009.

Laying the foundation for a healthy financial system is an essential part of the effort to rebuild the Icelandic economy. It is thus important that the ”new” and ”old” banks are restructured in a timely and appropriate fashion. It is also important that actions are taken by other banks with support from creditors, owners and the authorities to establish a robust capital base. This process should be concluded in a way where the state does not absorb any further private sector losses from the banking crisis.

19 March 2009

No. 11/2009