18 September 2007

Interview with Governor Ingimundur Friðriksson


“Firm need for ongoing restraint”

 Few people were surprised at the decision by the Board of Governors of the Central Bank of Iceland last week to keep the policy interest rate unchanged. However, doubts about the effectiveness of the Bank’s monetary policy have been raised in various quarters. Central Bank Governor Ingimundur Fridriksson rejects such claims outright and says that, on the contrary, the results have clearly been demonstrated in the slowdown in the rate of inflation. Grétar Júníus Gudmundsson met him to discuss the policy rate, financial market turmoil and the Icelandic currency.


The Board of Governors of the Central Bank has announced that the policy rate will be lowered as soon as the fundamentals are in place for doing so, but not before. Central Bank Governor Ingimundur Fridriksson says that the policy rate has definitely constrained inflation. Claiming otherwise is simply wrong. “If the Central Bank hadn’t tightened its stance, inflation would almost certainly be much higher than today, with all the disruptions and unease that entails,” he says.

The policy rate has been unchanged at 13.3% since the end of 2006. It was raised seven times in all last year, by a total of 3.3 percentage points. Since May 2004 there have been nineteen policy rate hikes.

In an interview with Morgunbladid at the end of last month, Vilhjálmur Egilsson, Director of the Confederation of Employers, described the Central Bank’s interest rate decisions as deadlocked and said that the Bank would never see the possibility of lowering the rate. This view has been echoed from elsewhere in the business sector.

Ingimundur Fridriksson disagrees completely. “Inflation was at a peak at almost 8½% at the end of summer 2006,” he says. “It has been falling slowly but surely since then, admittedly more slowly than we would have preferred, but there is no doubt in our minds that the main reason for the decrease has been our tight monetary stance. We also disagree with the view that we are deadlocked and will never be able to lower interest rates in Iceland.”


Enhanced methodology

According to the Governor, the Central Bank has gradually been modifying and enhancing its forecasting methodologies. The latest landmark was in March, he says, when the Bank began publishing its staff’s projection of the policy rate path alongside its inflation forecast. This practice was repeated in July, when the Central Bank expected to be able to lower the policy rate in the first half of 2008, which is slightly later than in its March forecast. The changes in monetary policy conduct have been well received, he says. Publication of the policy rate path has been particularly welcomed, and has exerted the impact on market expectations that the Central Bank was aiming for.

Announcing the Central Bank’s interest rate decision last week, the Board of Governors specifically stated that it saw no grounds for deviating from the July forecast. A new inflation and macroeconomic forecast will be published in Monetary Bulletin at the beginning of November, along with a new policy rate path projection.


Most important to achieve balance

Ingimundur Fridriksson says that claims from various quarters of the business sector that the Central Bank should have begun lowering the policy rate long ago may be interpreted as implying that the Bank should in effect have let inflation pass through by not applying a tight monetary stance. Such developments cannot be managed by switching inflation on and off at will, he says, to say nothing of inflation expectations. The way that developments have unfolded shows beyond doubt how difficult inflation can be to reign in.

“The most pressing economic management task in Iceland today is to achieve macroeconomic balance and all means should be applied to that end. This is in everyone’s interest. Inflation is a bad thing. It upsets the finances of heavily indebted households and disrupts business operations. Of course we are sailing a challenging course with a large current account deficit and underlying inflation that still measures 5-6%, but this compels us to achieve balance as soon as possible.”

Success in the battle against inflation requires an ongoing tight stance by the Central Bank, he says. It naturally also calls for ongoing fiscal restraint by both central and local government, and also a cautious approach in the labour market. The Central Bank has declared that it will respond to the inflation outlook whether it improves or deteriorates, and that this commitment will be kept.

“What is needed now is firm restraint in all fields of economic policy. We have applied such a stance in monetary policy and have in fact pointed out, most recently last week, that certain shortcomings in the monetary policy transmission hinder monetary policy measures from being transmitted in full, in particular to the long end of the bond market. Above all these shortcomings lie in mortgage loan arrangements. This issue needs to be addressed to enable the Central Bank to exert the influence that it needs to have. For as long as policy rate hikes are not delivered to that end of the market, real estate prices will continue to rise, as they have been doing in recent months.”

The Central Bank has also pointed out that the domestic bond market would be strengthened with increased bond issuance by the Treasury even though it has no need to raise credit. Some direct cost would be entailed for the Treasury but from a long-term perspective it would make the domestic capital markets more effective. The Treasury would then also have easier access to that market if it needs to make new borrowing.


Review of the Housing Financing Fund

According to Ingimundur Fridriksson, the Central Bank has no official view on the best way to reform the public sector mortgage finance system.

“What matters for the Central Bank is for reforms to be made that will enable monetary policy to have the intended effect. Another important consideration is that the future mortgage credit system will provide a solid foundation for the bond market. We have drawn attention to these points for several years, in our publications, opinions to parliament on draft legislation and reports to government ministers. However, precious little has been done. International agencies have also pointed out that a review of the role of the Housing Financing Fund (HFF) is long overdue. I could mention in particular the IMF’s Article IV Reports, most recently this summer. The fund’s reports show that its analysts have striven to make an in-depth study of mortgage credit arrangements in Iceland. We endorse the IMF’s remarks on this issue.”

He adds that the Central Bank is waiting for signs of a slowdown in the housing market. The Bank would have preferred to have seen such signs emerge already. In the current climate, it would unquestionably be of benefit if HFF mortgage interest rates were raised, as the commercial banks have done. But the HFF finances its operations with a Treasury guarantee at the longest end of the market, where yields have been lowest, allowing it a more moderate approach towards raising its interest rates recently.

“It would help us, however, if HFF mortgage interest rates were to rise by more than they have, so that yields at the shorter end of the indexed bond market would be more clearly reflected in the fund’s lending rate. The point of a tight monetary stance is to make credit more expensive and postpone investments and consumption until conditions change.”

The Confederation of Employers has voiced concerns about the consequences of the Central Bank’s monetary policy, claiming that it contributes to Iceland’s current economic instability. It has pointed out possible ways to change the price development objectives underlying the Central Bank’s inflation target, which it regards as potentially crucial for wage bargaining between the social partners. Among the proposals are to base the target on the CPI excluding housing price changes, which in recent times have accounted for roughly half of inflation. The Confederation of Employers also recommends abolishing the single numerical inflation target and has mentioned the possibility of setting a ceiling on Iceland’s interest rate differential with abroad.

Governor Fridriksson is not impressed by these ideas. “We regard the housing component as an advantage in inflation measurements. It captures a large share of households’ cost of living and the CPI including mortgage costs is a more stable gauge of inflation than if they are excluded. House prices are also a leading indicator. A sharp rise signals private consumption growth later on. So we do not want house prices to be excluded. In some inflation-targeting countries where mortgage costs are not included in the CPI, people regret not having them,” he comments, adding the same applies to the Confederation’s other ideas for changing the inflation target.

“We do not consider them an improvement. I think it is highly dubious to relax our inflation objectives. We should be able to attain the inflation target through sensible policies and effective market arrangements, and there is no reason for easing our demands.

“In our view, there is no question that a tight monetary policy has produced results. But the challenge we face lies in the economic expansion in recent years, which is partly driven by investments in the aluminium and power sectors and not least in the sudden changes in the mortgage loan market in 2004, which led to a surge in private consumption. We should remember that these changes occurred at the same time as global interest rates were at a historical low. If the transmission mechanism of monetary policy were smoother, if the fiscal stance were tighter from both central and local government, and if wage developments had been closer in line with the inflation target, inflation would be lower today. But we are still tackling large pressures in the economy, despite occasional claims that they are rapidly easing. The labour market situation indicates the opposite. Unemployment measures less than 1%. As long as labour market pressures remain at their current level, we cannot conclude that activity is slowing down.

“Last week we decided to leave the policy rate unchanged and announced that there were no grounds for departing from the inflation forecast that was published in July. We also stated clearly that if the inflation outlook takes a turn for the worse, the Board of Governors will respond, and likewise if prospects improve from the last forecast. Naturally we shall keep a very close watch on developments over the months to come. However, prospects are exceptionally uncertain at present due to global conditions, but the greatest uncertainty remains, as always, the exchange rate. The way it will develop very much depends on global market trends.”

Unease comes as no surprise

Ingimundur Fridriksson says it is impossible to predict whether a global economic recession lies ahead; the picture is still not clear enough. However, changes in the markets could have been expected. International analysts had repeatedly forecast a shift in the global environment, a point also made by the Central Bank in its publications. It was said that such changes could take place very rapidly.

“Global markets have been awash with liquidity in recent times. Interest rates have been at a historical low and in some cases unparalleled for the past hundred years. And appetite for risk has been enormous. It has also been pointed out that risks have been mispriced, with too narrow spreads between low and high investment grades. The situation had to change and that is precisely what is happening now. It was difficult to pinpoint precisely when this would happen, until problems in the US subprime market turned out to be the catalyst.

“No end is in sight to this sequence of events, but financial institutions around the world are clearly extremely cautious at the moment. Interbank markets have not been operating as smoothly as usual and have been illiquid. Central banks on both sides of the Atlantic have responded by providing additional liquidity facilities. This has not been needed in Iceland and there is no prospect that it will be. The focus is increasingly shifting to the possible impact of these developments – whether they will provoke an economic recession among major industrialised countries. Credit terms have tightened on account of the unease and that effect will be felt in Iceland. However, there are no particular indications of a looming crisis. There are no grounds for making such predictions now.”


Euro inadvisable

The debate on the króna and ideas for switching to the euro in Iceland has intensified recently. Ingimundur Fridriksson says it is not the Central Bank’s role to decide which currency is used in Iceland, which is a political decision. The Central Bank operates under an Act passed in 2001, which assigns it the main objective of promoting price stability along with others such as promoting financial stability.

“Nonetheless, the Central Bank has stated its view that it would be inadvisable to replace the króna with the euro in Iceland, except by joining the EU. And I think there are reasons to warn against acting rashly. For example, even if there was the slightest probability of Iceland eventually joining the EU, I think adopting its currency unilaterally would be particularly ill-advised. One reason is that we would then have to deploy part of our foreign reserves to purchase euros to put into circulation Iceland, while EU accession would render that unnecessary. There are currently notes and coin in circulation for well over 16 b.kr. Membership of the EU would automatically put euros into circulation in Iceland.

By adopting the euro unilaterally, we would lose our seigniorage, which although it is not particularly large would then accrue in whole to the European Central Bank. And we would reap none of the benefits of belonging to a monetary union, namely taking part in decision-making or enjoying the collective security and cooperation that this would entail.

“With the unilateral introduction of the euro, the Central Bank would presumably lose its role as a possible lender of last resort. It would no longer provide a potential safety net for financial companies and they would have no central bank to turn to. A final point is that, irrespective of the arrangements in which a new currency were introduced, the Treasury guarantees large amounts of indexed króna-denominated HFF bonds that have been issued in the domestic market on very long maturities and are noncallable. Since loans granted by the HFF can be repaid early, it is uncertain that its income would match outstanding obligations if the currency is changed.

Ingimundur Fridriksson says that the debate on the conceivable introduction of the euro sometimes sounds as if economic stability would automatically and instantly be achieved as a result.

“That is out of the question, of course. Sometimes it all sounds simply like an attempt to divert people’s attention away from current problems, but they do not vanish just because people stop thinking about them. Adopting a different currency would mark the end of an independent monetary policy in Iceland. Much greater responsibility would be imposed on the fiscal authorities and social partners to ensure stability. Were they to fail, Iceland’s competitive position would worsen, ultimately resulting in a recession and unemployment.”

The króna has served well so far

Finally, he pointed out that yet other ideas for pegging the króna to another currency were unrealistic. A currency peg would demand great sacrifices in order to be credible, and the support for such an action is questionable.

“I think it is advisable to proceed with caution and avoid decisions that might rebound on us later. Vested interests and long-term perspectives need to be borne in mind in the debate about which currency Iceland should use. Whatever the outcome, insistence on policies that ensure macroeconomic balance remains unchanged,” Ingimundur Fridriksson says. “And the króna has served us well so far and can continue to do so.

“Admittedly the króna has been volatile recently, but so have other currencies, including the main ones in the world economy. They have shown large swings against each other recently, which also has an indirect impact on the króna. Exchange rate volatility is certainly not comfortable, but it should be pointed out that hedges against its effects are available in the markets.”