Summary — 11 proposals from the task force on monetary policy reform
The task force has presented a total of 11 proposals that address four principal areas of monetary
policy. The task force has benefited from advice from foreign experts and from the International
Monetary Fund (IMF) in formulating its own proposals, which are, of course, the responsibility of thetask force itself.
 Three of the proposals centre on the framework for prudential tools, to ensure coordination
between financial stability and monetary policy. The role and responsibility of the Central Bank is
expanded, but alongside this increased authority, it is ensured that the Central Bank’s
responsibility and management processes in the areas of monetary policy and financial stability
will be strengthened.
 Two proposals for an improved inflation target ensure that the Bank will apply its policy interest
rate in a more effective manner without compromising financial stability.
 Two of the proposals centre on more targeted application of the Bank’s policy instruments. They
ensure clearer boundaries between monetary policy instruments, on the one hand, and financial
stability instruments, on the other.
 Four of the proposals centre on the monetary policy decision-making process and contribute to
greater transparency and increased discussion of monetary policy, with the aim of creating a more
broad-based public consensus on monetary policy and financial stability.

Three proposed reforms to the framework for macroprudential and monetary
policyThe application of macroprudential tools centres not only on maintaining financial stability — this new
way of thinking and/or methodology can also hone monetary policy by curbing credit growth and levaregein the economy. This has particular significance for small currency areas where a widening foreign interest
rate differential can cause balance of payments problems and create the risk of financial and economic
instability. These problems lie not only in foreign exchange market instability, but also in inflows of foreign
capital into the financial system, causing credit and asset price bubbles.
The understanding is now gaining currency that, because of the globalisation of capital transactions,
independent monetary policy is not truly an option for smaller currency areas unless it is possible tomanage the capital account, directly or indirectly, irrespective of the exchange rate regime in place. Thiscan be done with capital controls, but it can also be accomplished with appropriate application ofmacroprudential tools. Macroprudential tools can create a stronger foundation for independent
monetary policy in small, open economies by improving the transmission of monetary policy to the real
economy via the so-called credit channel. This would accomplish the task that capital controls were
designed to carry out, but at much less cost to the nation.
In the task force’s opinion, it is vital to designate one party that is responsible for applying
macroprudential policy and maintaining financial stability. Furthermore, it is important that theinstitutional framework contribute to improved coordination in the implementation of macroeconomic
policy and conventional monetary policy. Moreover, it is important that the limited human resources inour small country be utilised as efficiently as possible in analysing and collecting information. The current
macroprudential framework dates from 2014 and was intended at that time to be only a temporary step,
until the Central Bank assumed sole responsibility for macroprudential policy. The time has come to takethat step.
At the task force’s request, Kristin Forbes has reviewed the application of macroprudential policy for
Iceland. Her conclusions are outlined in her report. In Kristin Forbes’ opinion, Iceland is well advanced visà-vis other countries as regards macroprudential policy. However, she recommends significant changes
to the formal economic policy framework — changes that the task force wishes to include in its proposal,
which is actually in line with the opinion of other foreign consultants that have addressed this issue
previously.
Proposal 1: The Central Bank of Iceland shall be solely responsible for macroprudential andmicroprudential policy and shall have oversight of analysis, decision-making, and application of all
macroprudential tools. Prudential supervision shall be transferred in its entirety to the Central Bank.
The proposal above entails placing all macroprudential and microprudential policy under the aegis of one
institution, the Central Bank of Iceland. Responsibility for this will therefore be transferred from the
Financial Supervisory Authority to the Central Bank, and the division of tasks between these two
institutions will be clearer. This change will increase the weight of financial stability in the Central Bank’s
activities. The Financial Supervisory Authority will remain the supervisor of the financial markets.
Placing all prudential tools in one institution will make the entire process, from analysis to decisionmaking, more efficient. Analysis, decision-making, and responsibility are all with the Central Bank.
Furthermore, analysis work will be stronger and broader with information and specialised staff in thesame place.
Concurrently, the Central Bank’s responsibility and management role must be strengthened with theappointment of a separate Deputy Governor who will focus on macroprudential policy. In addition,
another Deputy Governor will focus on monetary policy. It is assumed that there will still be one Governor,
who will be the most senior official at the Bank and will be responsible for its operations. These three,however, will create a multi-member authority. This does not entail, however, a return to the previous
structure, with three governors of equal stature, for according to the old adage, there can only be one
captain on each ship. On the other hand, there are various decisions pertaining, for example, todiscretionary policy that would be best placed in the hands of a multi-member authority. This refers inparticular to communications with financial institutions, such as for lending of last resort, or decisions onmarket intervention falling outside the scope of rule based economic policy.
Proposal 2: Two Deputy Governors shall be appointed, one to focus on financial stability and theother to focus on conventional monetary policy. Both of them will be members of the Board ofGovernors, together with the current Governor. The Board of Governors shall constitute a multimember authority that will take decisions on matters relating to discretionary policy.
The division of tasks will be as follows:1. Governor The Bank’s highest-ranking official — a CEO of sorts. The Governor is also the chair of
the Board of Governors, is responsible for the Bank’s operations, and is the representative of the
Bank and the Board of Governors. Is a member of the Monetary Policy Committee, the Systemic
Risk Committee, and the Financial Stability Committee.
2. Deputy Governor for monetary policy: Oversees monetary policy. Is a member of the Monetary
Policy Committee and the Systemic Risk Committee.
3. Deputy Governor for financial stability: Oversees macroprudential and microprudential tools. Is amember of the Monetary Policy Committee, the Systemic Risk Committee, and the Financial
Stability Committee.
Concurrent with this changed role of the Central Bank and the increased responsibility for financial
stability, it is also important to clarify the division of tasks among committees, and to ensure cooperationand synergy between monetary policy and macroprudential policy. The task force makes the following
proposal.
Proposal 3: The number of external members of the Financial Stability Committee shall be
increased, and the Committee shall take final decisions on the application of all macroprudential
tools.
It is recommended that the Financial Stability Council be replaced with a Financial Stability Committee,
with both the Governor of the Central Bank and the Minister of Finance and Economic Affairs acting aschairpersons. The Committee will also include the Deputy Governor for financial stability and two external
members, at least one of whom must have experience in the financial world. It is recommended thatvoting on the application of macroprudential tools take place within the Financial Stability Committee andbe made public when changes in policy instruments are announced. Final decisions on the application ofprudential tools shall therefore be in the hands of the Financial Stability Committee. The Systemic Risk
Committee will continue to oversee analytical work, present proposals on the implementation ofprudential tools to the Financial Stability Committee, and oversee the implementation process.

Two proposals on changes to the Central Bank’s inflation target
During the years prior to the financial crisis, there was debate about what role monetary policy shouldhave vis-à-vis asset prices — or, more precisely, bubble formation in asset markets. This debate was often
accompanied by the term “lean or clean” — i.e., whether central banks should lean into the wind andraise interest rates to push against rising asset prices or leave the asset markets alone and focus only on
cleaning up after bubbles have burst.
This debate has subsided over the years, however. Instead, a consensus appears to be developing thatinterest rates are relatively toothless against financial bubbles. It has been said that an interest rate levelthat would suffice to curb an asset bubble would be so high that it would paralyse the real economy andtherefore be enormously costly. By the same token, such a steep rise in interest rates would cause severe
problems in the foreign exchange market, with an overly high real exchange rate and a current accountdeficit, which would certainly undermine financial stability.
The discussion above on the division of tasks centring on macroprudential policy, on the one hand, andmonetary policy, on the other, concurrent with increased emphasis on financial stability, is of considerable

importance for the Central Bank of Iceland, particularly in view of Icelanders’ bitter experience of the 2008
financial crisis.
The current cooperation agreement between the Government and the Central Bank, dated 27 March
2001, assumes that the inflation target will always take priority over financial stability. Given the social
costs associated with financial instability, financial stability must be given priority over price stability ifsuch circumstances develop. Furthermore, the maintenance of financial stability must set certain
boundaries on monetary policy implementation. As a result, the task force recommends the followingchanges.
Proposal 4: The cooperation agreement between the Government and the Central Bank of Icelandshall be amended so that the maintenance of financial stability will take priority over the
maintenance of price stability if circumstances develop so that the former is in jeopardy. In such
instances, the Monetary Policy Committee shall allow inflation above target so as to give the
Financial Stability Committee the scope needed to apply macroprudential policy.
In Iceland, over a fourth of the consumer price index is attributable to house prices. This can cause a
detrimental overlap between price stability objectives and financial stability objectives. This is not only
because the Bank must apply interest rates to control house prices, which account for 25% of the Bank’s
inflation target, but also because the Bank’s interest rates have a very limited impact on house prices, astransmission of the policy rate to long-term indexed interest rates is extremely weak in Iceland, andstatistically insignificant. Statistics Iceland also estimates housing costs in the CPI, by using the so-calleduser cost method, which is based on a three-month moving average of house prices. Given the wide
fluctuations in real estate prices in recent years, this method of measurement causes short-term
fluctuations in inflation that the Central Bank is required by law to address.
It is emphasised here, however, that the independence of Statistics Iceland is as important as theindependence of the Central Bank. It is important that measurements of inflation be as credible andaccurate as possible. The task force therefore does not take a position on which method of measurement
gives the most accurate view of housing costs, and it is clear that there are very strong theoreticalarguments in favour of Statistics Iceland’s current method. At the same time, this method of measuring
housing costs makes the CPI a very unfortunate criterion for the inflation target, as short-term fluctuations
in house prices are transmitted to inflation with a time lag and the transmission of the Central Bank’s
policy rate to long-term mortgage rates is very weak. Applying monetary policy in a manner that addresses
these fluctuations in housing costs — such as by trying to bring about a reduction in import prices with ahigher exchange rate — creates the risk of extremely a high sacrifice cost associated with the choice
between price stability, on the one hand, and output, on the other.
In this context, the task force takes the basic position that house prices do not belong in the Central Bankof Iceland’s inflation target. There are several ways to accomplish this: the Bank could use a different
index, such as the CPI excluding housing or the Harmonised Index of Consumer Prices (HICP). The task
force is of the view that such options should be explored thoroughly.
Proposal 5: The Central Bank’s inflation target shall remain 2.5%, but the price index to which thetarget applies shall not be based on the cost of owner-occupied housing. The inflation target shalltherefore explicitly exclude house prices.

Two of the proposals centring on more targeted application of policy instruments
Since the 2008 crash, foreign exchange market intervention has played a major role in monetary policy
implementation. This was particularly the case in 2014-2016, when the Bank’s purchases accounted for
50-70% of total market turnover, although intervention has been almost non-existent since 2017. It isclear that market intervention will continue to play a large role in Icelandic monetary policy in the future,in the attempt to ensure price stability, as monetary policy transmission takes place to a large degree
through the foreign exchange
The task force engaged Sebastian Edwards to focus in particular on the Bank’s intervention in the foreignexchange market in a report entitled Monetary Policy in Iceland: An evaluation. He recommends that aso-called “traffic light system” like that used by the Reserve Bank of New Zealand (RBNZ) be used as abasis for the Central Bank’s intervention policy. The task force recommends that the Central Bank adopt
the traffic light system used by the RBNZ, in accordance with Sebastian Edwards’ recommendation. This
also entails that the Bank will publish its estimate of the equilibrium real exchange rate concurrent withits macroeconomic forecasts.
Proposal 6: The Central Bank of Iceland shall use the RBNZ’s traffic light system to create clear
ground rules for decision-making and communication of information on foreign exchange market
intervention. Furthermore, there is need for a clearer and more transparent sterilisation policy inconnection with intervention. Furthermore, the Bank shall publish its assessment of the equilibrium
real exchange rate on a regular basis.
The above-mentioned traffic light system is very general, of course — a more detailed framework will
doubtless be developed based on practical experience. It should create a set of ground rules forintervention, however, which have not been in place heretofore. This will create a framework for decisions
made by the Monetary Policy Committee and will better enable the Bank to explain its policies anddecisions to market agents and the general public alike. Furthermore, this should give the threecommercial banks, which constitute the interbank foreign exchange market, the scope to create enhanced
short-term stability in the market through smoother price formation. It is important as well to bear inmind that such an intervention policy cannot entail a fixed exchange rate policy, a pledge that the Central
Bank of Iceland will use its reserves to maintain a given exchange rate, nor can it be expected that foreignexchange market intervention will have a long-term impact on the exchange rate of the króna.
In June 2016, special restrictions were imposed on capital inflows. It was said that the purpose of theserestrictions was to combat “excessive inflows of capital” that could lead to the accumulation of systemicrisk in the economy. The Central Bank has also explained the origins of the restrictions as a response todisturbances in the transmission of the policy rate caused by inflows of foreign capital. In the IMF’s June2017 report on Iceland, it is strongly recommended that the 40% special reserve requirement be lowered
to zero, as it cannot be seen that conditions actually called for its use. Sebastian Edwards and Kristin
Forbes concur with the IMF’s opinion that under current conditions, the grounds for restrictions on inflows
are weak, as before they were imposed, the scale of the inflows was not large enough to have underminedfinancial stability and that such a risk could have been averted with other types of macroprudential tools.

Moreover, Kristin Forbes mentions three conditions that shall always be considered before imposing
inflow restrictions:
1. When economic imbalances have developed, when the króna is priced too high, and it is notpossible to use other macroprudential tools to address such an imbalance.
2. Inflow restrictions are then imposed as a temporary measure if the impact of other policy
instruments will be lagged.
3. When capital inflows jeopardise financial stability.
The fact is that restrictions on international trade are a very clumsy tool that do damage when applied.
The imposition of restriction must be regarded as the last line of defence — or last-resort economic policy.
It is difficult to conclude otherwise than that the current use of inflow restrictions runs counter to expert
advice and that the restrictions are imposed primarily to strengthen monetary policy implementation
along the interest rate channel.
That being the case, the task force wishes to emphasise that the inflow restrictions are not a monetary
policy tool but a macroprudential tool to ensure financial stability. Decisions on the application of suchtools should be in the hands of a Financial Stability Committee, together with other decisions on the useof macroprudential tools. Although inflow restrictions will continue to be part of the Central Bank’s policy
instruments, it is important that there be clear rules governing when they are deployed.
Proposal 7: Inflow restrictions shall be within the purview of the Financial Stability Committee andpart of macroprudential policy, and shall be lifted in stages. For the future, clear rules shall govern
when they are imposed.

Four proposals for a more efficient decision-making process
Even though the change that took place with the new Central Bank Act in 2009, when the Monetary Policy
Committee was entrusted with taking interest rate decisions, was a significant step forwards, it is also
clear that the Committee’s transmission of interest rate expectations is not optimal. It can be seen in thebond market response following the Bank’s interest rate decision dates: the Bank’s decisions constantly
appear to take the market by surprise, which means that the decisions are at odds with the expectations
that had developed beforehand. For example, fluctuations in market yields in Iceland on interest ratedecision dates are as much as three times those in Sweden and twice as much as those in Norway. This
indicates a need to manage expectations more effectively, enhance the transparency of interest ratedecisions, and give more effective forward guidance on interest rate setting.
One way the Central Bank could improve the management of expectations would be to have the Bank’s
Economics Department publish the interest rate forecast paths underlying its inflation forecasts. The
department did this in 2007 and 2008, with good results.
The theory behind this is not unequivocal, however. The policy rate forecast is prepared by the Bank’s
Economics and Monetary Policy Department, but another party — the multi-member Monetary Policy
Committee — takes decisions on interest rates themselves. Each member of that Committee is there onhis or her own premises and expertise — and is expressly expected to take independent decisions basedon forecasts prepared by the Central Bank itself. Therefore, in no way can the policy rate forecast oblige
the Monetary Policy Committee. In the task force’s view, the publication of a policy rate path could
potentially enhance the credibility of the inflation target by showing the Bank’s interest rate response toinflation further ahead — as well as managing market expectations more effectively.
The task force considers it important, however, that in order to improve management of expectations,the discussion should be directed more at the future with the publication of the Central Bank Economics
Department’s policy rate forecasts.
Proposal 8: The Central Bank shall publish the policy rate path in Monetary Bulletin four times ayear. In this way, it will be possible to strengthen market expectations and enhance transparencyof the Bank’s long-term interest rate policy.
In this environment, it will be necessary to strengthen the Monetary Policy Committee’s operationalframework. At present, the external members of the Committee receive relatively little professional
support from the Bank, as they have no direct access to Bank staff, nor do they have their own employee
to assist them with analysis or verify their own conclusions. Furthermore, external members are paid
relatively little for their work, although they have relatively limited duties, which entail attending
informational and presentation meetings with Bank staff on the days prior to interest rate decisions.
The purpose of appointing external members in the first place is to apply some sort of checks and balances
to the Central Bank and provide for the expression of counterarguments to opinion that may have become
institutionalised within the Bank. For instance, it is also true that external members do not publicise thegrounds for their votes after each interest rate decision. Anything relating to the Monetary Policy
Committee’s interest rate decisions has informational value for market agents, households, andbusinesses. In this context, it would be positive that the voices and opinions of external members should
also be heard — so that parties outside gain a more accurate feeling for which points are debated within
the Committee — and which factors are important at any given time.
In view of this, the task force considers it important to expand external Monetary Policy Committee
members’ responsibilities and provide them with better support, which is in line with the practice of otherforeign central banks that have external Monetary Policy Committee members. Furthermore, theCommittee is advised to give more consideration to forward guidance, particularly so-called Delphic
forward guidance. In providing Delphic forward guidance, a central bank gives indications concerning
developments in short-term interest rates, depending on how certain economic variables develop. Thishas been done by the Monetary Policy Committee to good effect in connection with negotiation of wage
agreements, and it is therefore possible to build on that success.
Proposal 9: The responsibilities of and support given to external Monetary Policy Committee
members needs to be increased. Decision-making should be made more transparent with the
publication of individual members’ votes at the time of the decision. The Committee should giveincreased consideration to Delphic forward guidance in connection with interest rates.
Transparency is the foundation of an inflation target; it is the premise for evaluating a central bankaccording to the work it does; and it is the basis for professional and fair discussion of monetary policy
objectives and options. For example, the public should be able to understand the short-term tradeoffs

inflation versus unemployment, and why painful measures must sometimes be taken to ensure pricestability. This means that central banks must speak directly to the public so that their objectives will beachieved. It is very important to follow up on the success that has been achieved in enforcing the inflation
target. It is clear that the price stability of the past 4-5 years has delivered enormous benefit to the publicthrough increased purchasing power — and it is important that this be valued appropriately. In addition,a greater public consensus on the policy is needed.
In the task force’s opinion, the Central Bank of Iceland has not carried out its educational role well enoughas regards either monetary policy in general or the Bank’s role. That said, it is acknowledged that the past
few years have been unusually busy and complex. As the old adage says: It may have been necessary then,but it is imperative now.
Proposal 10: The Central Bank shall contribute to increased information on monetary policy andthe value of the inflation target, with the aim of enhancing the general public’s understanding of
the possibilities available and the limitations in place, and with the objective of contribute to greater
consensus on policy.
The current external review is the first of its type. Most foreign central banks have such a review carriedout on a regular basis, however. Regular reviews of monetary policy provide central banks withprofessional oversight and should generate healthy discussion of monetary policy in general, if not
creating a general consensus on the framework and conduct of monetary policy. Furthermore, regularreviews of monetary policy ensure that the pros and cons of the framework as current at any given time
will be evaluated.
Proposal 11: A regular external review of monetary policy shall take place every five years. Such a
review is conducive to greater harmony and support for monetary policy conduct, as well as
providing the Bank with professional oversight.