The Central Bank’s interest rate decisions affect short- and long-term interest rates, financial market liquidity, the supply of money in circulation and bank lending, currency exchange rates, the price of other financial assets, and last but not least, market participants’ expectations of future developments in all of these. All of this then affects individuals’ and firms’ investment decisions, thereby affecting overall demand and, ultimately, inflation.

The Central Bank’s interest rates on its transactions with financial institutions first affect other short-term rates in the money market, where transactions with short-term securities take place. Through price formation in the financial market, the effects are transmitted across the yield curve. The Central Bank’s key interest rate is its rate on transactions with credit institutions that is the strongest determinant of developments in short-term market rates – and therefore of the monetary stance. However, the rate that exerts this influence may not be the same one at all times; therefore, the rate that is considered the Bank’s key rate can change as well.

Changes in Central Bank interest rates have a broad-based impact on the domestic economy. For instance, rate increases usually cause interest rates on savings, outstanding short-term debt, and long-term variable-rate debt to rise as well. Under such conditions, households and businesses with outstanding net debt will see a decline in their disposable income – i.e., what is left after interest is paid. As a result, they cannot maintain the same level of spending and investment as before unless they take on more debt or deplete their savings, both of which are more expensive options than before. In the same manner, monetary policy affects households’ and businesses’ cost of financing new activities. Other things being equal, higher interest rates reduce individuals’ and firms’ consumption and investment spending.

Interest rate reductions work in a similar manner, but with the opposite effect.

An important part of the monetary policy transmission process takes place through the credit system. The interest rates that credit institutions can offer to individuals and businesses – i.e., how favourable the rates on offer are – is determined to some extent by the interest rate terms offered to credit institutions by the Central Bank. All other things being equal, higher lending rates reduce demand for credit. They can also reduce the supply of credit, as credit risk can increase because, for instance, households’ net wealth declines (see below) and firms’ market value falls and their cash flow deteriorates

Another monetary policy transmission channel is through its effect on the exchange rate of the króna. If interest rates on domestic securities are higher than on comparable foreign securities, it is favourable to own domestic securities, provided that the exchange rate of the króna remains stable. By widening the spread between domestic and foreign interest rates, the Central Bank can stimulate capital inflows or curb outflows; i.e., it can stimulate demand for krónur. Therefore, under normal circumstances, an interest rate increase contributes to the appreciation of the króna (or tempers the depreciation), which in turn contributes to lower import prices, which has a direct downward effect on inflation, other things being equal. Because changes in the exchange rate of the króna change relative prices of domestic versus foreign goods and services, thereby affecting the competitive position of domestic firms vis-à-vis foreign competitors, they also affect external trade and domestic demand. When the króna appreciates, foreign goods become relatively less expensive than before, which directs demand outside the domestic economy – again, other things being equal. Demand for domestic production therefore contracts, which should also lead to declining inflation.

Central Bank interest rates can also affect the price of assets – equity securities and real estate – thereby affecting households’ and firms’ net wealth. Other things being equal, higher interest rates should lead to lower share prices: first of all, because their price is discounted by the higher interest rates; second, because demand for bonds increases at the expense of equity securities when bond interest rises; and third, because higher interest rates tend to increase firms’ cost of capital and cut into their profits, ultimately affecting their ability to pay dividends to shareholders. By the same token, the cost of real estate financing rises, cutting into demand for housing and containing the rise in house prices. Declining share and house prices reduces individuals’ wealth, thereby reducing their proclivity and capacity to spend. Declines in share prices also reduce firms’ market value, which makes it relatively less favourable to issue new share capital to finance new development.

Finally, monetary policy affects general expectations of future developments in factors such as GDP growth and inflation, and the uncertainty attached to such expectations. Such changes in expectations affect the behaviour of financial market agents and others, including individuals’ expectations concerning the employment outlook and businesses’ expectations concerning future sales and profits. An increase in Central Bank interest rates can be interpreted to mean that the Bank considers it necessary to slow down economic activity so as to bring inflation to target. In such cases, the GDP growth outlook will have deteriorated in the wake of the interest rate hike, but the likelihood of price stability will have been enhanced. If the policy action is credible, it should reduce inflation expectations and support the measures taken by the Bank in order to stabilise inflation.

International research indicates that, in general, the effects of monetary policy actions are first felt in domestic demand after about six months and that the bulk of the impact has emerged after about a year. The first effects on domestic inflation generally appear after about a year, and the bulk of them have come to the fore by about 1½-2 years after the rate increase. The transmission channel is broadly the same in Iceland as it is elsewhere, as is described in the handbook for the Bank’s quarterly macroeconomic model (QMM).

It is well to emphasise that the monetary policy transmission mechanism can change from one period of time to another and is subject to considerable uncertainty as regards both the strength of the ultimate impact and the time lag between changes in a central bank’s interest rates and the effect on the real economy. The effectiveness of monetary policy probably depends in large part on its impact on the public’s expectations and the confidence placed in it. It is therefore of vital importance to enhance such confidence by conducting monetary policy in a transparent, credible way.

A detailed discussion of monetary policy transmission can be found in the article by Thórarinn G. Pétursson, “The monetary policy transmission mechanism”, in Monetary Bulletin 2001/4, and in the handbook for the QMM: “QMM: A Quarterly Macroeconomic Model of the Icelandic Economy”, Ásgeir Daníelsson, Lúdvík Elíasson, Magnús F. Gudmundsson, Svava J. Haraldsdóttir, Lilja S. Kro, Thórarinn G. Pétursson, and Thorsteinn S. Sveinsson.