Reykjavik, June 6, 2018

Iceland’s monetary policy regime
Patrick Honohan
Based on“Reassessing Iceland’s Monetary Regime”
by Patrick Honohan and Athanasios Orphanides

Monetary policy issues we noticed• Inflation is on target– Thanks partly relatively high interest rates (building reserves)– And some luck
– Even though real growth strong• But stripping out house price component shows that other prices
have been falling– CPI may mislead in the short run• Exchange rate volatility a complicating factor for policy– Wide movements destabilize real economy and inflation• As is the prevalence of index-linked mortgages– Which weaken transmission of monetary policy• “Macroprudential” tools are needed relevant for monetary policy
also– Including effect on pension fund lending• This suggests governance changes– Merge CBI and FME

What we noticed about Iceland’schequered inflation history• Economy vulnerable to shocks• Depreciation was used to respond to shocks• With limited success in terms of real economic
activity• Inflationary surges a side-effect• By the early 1990s an anti-inflation consensus
had built and soon inflation came under control.
• Though slippage returned even after formal
inflation target (IT) regime introduced in 2001

Inflation

Ensuring price stability - 1• Price stability is the core task of any central bank.
– It is measurable. So CB can be held accountable– Don’t water this down.

• We examined how CB is doing this job and find it
generally in line with international consensus….
• [We make some suggestions including– To improve communication– To avoid destabilising effect of house prices on thetargeted CPI]Ensuring price stability - 2• But some Iceland-specific aspects deserve attention– Prominence of index-linked housing loans (not so easily steeredby CB using short-term interest rates)– Large role of nonbanks in the housing finance market– Importance and volatility of exchange rate

• Make sure the CB has the tools to do the job and is willingto use them:– Macroprudential tools to augment interest rate policy– Willingness to use FX intervention especially to restrain
unwarranted FX appreciation surges– (But be careful with unrealistic attempts to resist depreciation)– If necessary including taxes/controls on currency speculation –but don’t lead with theseEnsuring financial stability• Financial stability is also a key task of equal if not greater
importance–but don’t weaken commitment to pricestability• Communication between prudential regulator andmonetary policy is vital– The policy measures taken by each influences the ability of theother.

• In a small country better to merge into one institution.

– But even then it will be vital to ensure perfect flows of
information and policy interaction between prudential regulator
and the bank
– Some intrusive macroprudential tools should continue torequire political approval – but to avoid inertia, CB’s proposals
should be published even if not politically acceptedEnsuring price stability - 3• Price stability is the core task of any central bank.
– It is measurable. So CB can be held accountable– Don’t water this down.

• A new mandate?
• Prioritising financial stability over price stability ina new mandate could seem unexpectedly out ofstep with international practice and trends…
– (cf Norway, New Zealand, etc)

Indexed mortgage loans and the roleof pension funds in housing loans• Pension fund activity very relevant for macroeconomicstability.

– (These large institutions also raise important competitionand prudential issues)• Indexed interest rates may not respond sufficiently
strongly to monetary policy nominal interest rates• So policy rate may need to be supplemented bymacroprudential tools• Close cooperation needed between monetary policy
and prudential regulator– (Why not merge these – in a small economy)

Share of indexed andforeign exchange debt

Key policy rate and indexed interest rates

Exchange rate
• Recent stabilization has seen rapid exchange rateappreciation– Partly a consequence of high interest rates• Maybe converging to new equilibrium realexchange rate reflecting tourist boom
• Fixed exchange rate a viable option? We say no!
– (e.g. too vulnerable to speculation)• But Sedlabanki could use tools to limit large
exchange rate appreciation more aggressively

Housing component of CPI• Is measured professionally within international
standards,• But emphasizes short-term housing pricemovements more than is useful for inflation
targeting• Recently CPI inflation on target but non-housing
prices were falling• Sedlabanki should allow CPI to deviate fromtarget temporarily if housing prices are moving
rapidlyHeadline inflation andinflation excluding housing

Communication issues• Does the general public really understand what
the central bank is for and what it is doing?

– This will become more important with wider range of
responsibilities• Individual votes of monetary committee
members should be published more promptly– Committees work better for these decisions thanindividuals.

• CB proposals (even rejected) on macropru shouldbe published (as mentioned)