24 October 2005

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 Iceland and the risks that they could face. I shall discuss here the former objective, i.e. the monetary policy rule of aiming for a low rate of inflation. To achieve this objective the Central Bank has only one instrument, namely the interest rate that applies to its transactions with credit institutions.

Monetary policy

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 Iceland moved on to an inflation target and abandoned targeting of the exchange rate. Immediately after the changeover, the króna slid and there was an inflationary spike. This proved only short-lived and in 2002 the rate of inflation slowed rapidly and remained low until 2004, but has been on the increase since the first half of this year. In appraising how suitable an inflation-targeting policy is for Iceland, we need to take into account the extremely unusual conditions that have prevailed over the second half of the period since it was adopted. The largest investment programme in Icelandic history was launched, foreign interest rates have been at their lowest level for a century and sweeping structural changes have taken place in domestic financial markets. Even though inflation is currently beyond the target, I do not consider this to be the slightest proof that inflation-targeting is unsuitable for Iceland. It has been in place for too short a time to pass judgement.

Unfolding developments

When it was decided to build an aluminium smelter and hydropower station in east Iceland, the economy was in very good balance. At that time, the Central Bank was of the view that, despite their massive scale relative to the Icelandic economy, these investments could be prevented from causing severe imbalances by appropriate economic policy measures.

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 Iceland projects, it was decided to expand another aluminium smelter in southwest Iceland with accompanying power supply projects. Rescheduling of construction work also resulted in much more intense activity in 2005 than had originally been planned. Initially, the investments were expected to be spread over a longer period and to peak later. These changes made it more difficult to respond with appropriate measures.

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 Iceland and abroad to widen and it is now at a record level since cross-border financial transactions were deregulated. In most other industrial countries, interest rates are at or close to a historical low. Investors are therefore searching out investment opportunities that offer higher yields than are generally available. Recently they have focused on the Icelandic króna, as we have all heard. In itself this development is not surprising – it is an offshoot of unrestricted cross-border capital movements. Icelandic investors have had open access to financial markets abroad and international investors are now turning their attention to the Icelandic króna. This is only natural and we must adjust to this new environment. In particular, the short-term effects have been seen in falling yields on certain series of government instruments in the domestic market and in the appreciation of the króna. The extent of the exchange-rate impact is difficult to evaluate. However, it seems certain that the króna is currently stronger than it would have been had these bond issues not been made. What the long-term impact will be is impossible to say. The international issues that have been made are at various maturities, so they will not all fall due at the same time. Conceivably, this development may have created a stock of bonds which will be maintained, so that Icelandic issues could form part of foreign investors’ portfolios in the future. It is impossible to say anything absolute at this stage. Foreign investors have a very limited experience of trading in Icelandic currency. We know that investors have been making efforts to obtain information about Iceland, the position of the króna, the economy in general and the outlook. This means that they have sought to make informed decisions about investments in króna-denominated bonds. Time will tell how profitable their investments turn out to be and how much interest they show when the interest-rate differential with abroad narrows again.

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 Iceland has published its procedural rules on monetary policy decisions and stated that they would be reviewed as circumstances warranted. One possibility would be to announce the monetary policy decision dates in advance. This has been under discussion and examination in the Bank for some time and it is conceivable that specific interest-rate decision dates will be announced in the not so distant future. More dates might be announced than the publication dates of Monetary Bulletin, so that on the other days the Central Bank would issue an announcement on its interest-rate decision, either to change the policy rate or leave it unchanged.

Should the Central Bank boost its foreign reserves with more currency purchases?

Ideas have been raised for increased Central Bank purchases of foreign currency, with two aims: to boost Iceland’s foreign reserves and to contribute to a depreciation of the króna or to prevent it from appreciating further. The Bank currently purchases twelve and a half million US dollars a week, of which ten million are to meet Treasury repayments of foreign borrowing next year. At the moment, therefore, a considerable replenishment of the reserves is taking place. No decision on further purchases has been announced, but this would obviously depend on the Bank’s view as to what the level of foreign reserves should be. In other words, it would not be based on bringing about a change in the exchange rate, since the Bank does not target the exchange rate. Central bank interventions in foreign exchange markets have a limited impact on the exchange rate anyway, except over the very short term. Also, the Central Bank’s currency purchases increase liquidity in circulation, which could create other problems.

Should price-indexation of financial obligations be eased?

It has been claimed that the extensive use of price-indexation of capital in Iceland causes a lag in monetary policy transmission, so that the possibility of whether its use could be reduced needs to be explored. A number of arguments have been put forward in favour of relaxing indexation. At one time it was maintained that this was a prerequisite for bringing down the rate of inflation. This has now been decisively disproved. Another claim is that indexed loans are expensive for borrowers. In this context I point out that non-indexed loans are more expensive as a rule. However, borrowers need to realise that when they take an indexed loan, they are in effect agreeing to several future loans, because the price adjustment factor on each due date a large part of the price adjustment factor is added to the principal, and thus represents a new borrowing. As a result, debt service on indexed loans is back-loaded, i.e. easier at the beginning than towards the end. It is only natural to examine price indexation carefully from the viewpoint of whether abolishing or reducing it could enhance the efficiency of monetary policy by enabling the effect of Central Bank interest-rate changes to be transmitted through the economy at an earlier stage. However, it is uncertain that this is the case. It may be pointed out that interest rates on indexed securities in Iceland have been moving up slightly in the past few days, and the most immediate explanation is that they have been driven by the last change in the Central Bank’s policy interest rate.

Would it be appropriate to adopt the euro?

Some people advocate that Iceland should adopt the euro as its currency, even without EU membership. This issue has been discussed in publications and speeches by the Central Bank and others.* The Central Bank has cautioned against a simplistic view of Iceland’s options in this respect. If the government of Iceland unilaterally decided to adopt the euro as the national currency, this would certainly result in lower interest rates, but such a measure has numerous drawbacks for an independent state and conceivably would not be taken with the blessing of the European Central Bank. The exchange rate would no longer exist as an economic policy instrument and safety valve. In the present climate the rate of inflation would certainly be higher than it is now, and if an economic contraction in Iceland coincided with an upswing in the EMU countries, unemployment would probably increase. It is very unlikely that Iceland would be offered membership of EMU without joining the EU. Even in the unlikely event of Iceland being offered such associate membership, it would almost certainly need to meet the Maastricht criteria. These include a low rate of inflation, low interest rates and membership of ERM2 for at least two years without the exchange rate moving beyond the fluctuation band. Iceland will obviously not fulfil these conditions in the immediate future. It may be pointed out that several Central and Eastern European countries have recently acceded to the EU and seek admission to EMU at a later stage. The ECB and other EU leaders have firmly underlined that it is vital for these countries to fulfil all conditions for EMU participation. This makes it highly unlikely that any precedent would be set that they might be able to take advantage of as a short-cut into EMU.

Iceland has opted to remain outside the EU and has not declared an interest in membership. If Iceland wanted to adopt the euro as its currency, the obvious step would be to join the EU with all the advantages and disadvantages that accompany it, including membership of EMU. Such a decision, however, is determined by more factors than national currency issues, and the process would take quite a few years. This is of course above all a major political task. Iceland therefore has to go ahead as a country with its own currency, which in a climate of free capital movements demands highly disciplined economic policies.

Monetary restraint

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 Iceland: Efnahags- og Myntbandalag Evrópu – EMU, sérrit 2, 1997 [Occasional paper]; Office of the Prime Minister of Iceland: Áhrif Efnahags- og myntbandalags Evrópu á íslenskt efnahagslíf. Committee report, June 1998; Birgir Ísleifur Gunnarsson: Monetary policy, economic growth and prosperity. Speech at a seminar organised by the Iceland Trade Council, Euro Info office in Iceland and the EU Commission on the theme: Does the euro affect Iceland?, published in Monetary Bulletin 2001/4.