MONETARY POLICY IN ICELAND:AN EVALUATION

by

Sebastian Edwards
Henry Ford II Distinguished Professor,
University of California Los Angeles

June, 2018

This report is based on the author’s visit to Reykjavik in October 2017. He thanks
the number of people with whom he met for their time and generosity. In
particular, he thanks Ásgeir Jónsson, Ásdís Kristjánsdóttir, and Illugi Gunnarsson
for their hospitality, support, and detailed comments. He is grateful to SigrúnÓlafsdóttir for her assistance and guidance. Professor Kristin Forbes provided
very helpful comments. Comments and suggestions by Thor Pétursson were very
helpful, as were the comments by members of the IMF’s Iceland team. Opinions
are solely the author’s responsibility. A preliminary draft was circulated during
the first week of December, 2017; revised versions during February and April
2018.

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Table of Contents

Executive Summary

Introduction

Part One: Monetary Policy Options: Reflections based on IcelandPart Two: An assessment of current monetary policy in IcelandPart Three: Conclusions and recommendations

Annex: Models for assessing exchange rate equilibrium: A brief review and somereflections regarding Iceland

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EXECUTIVE SUMMARY

1.

The purpose of this report is to evaluate the current monetary policy regime in
Iceland, and determine if it needs to be changed, reformed, or adjusted. A restrictionof the analysis is to consider only regimes with a national currency -- that is, joining
an existing monetary union, or adopting another country’s currency as legal tender
are not considered to be options. 1

2.

The report has an Introduction, three main parts and an annex: In Part One I provide
some reflections on monetary and exchange rate policy options. This part does notpretend to be a primer on these subjects, but rather a brief synthesis that will help put
things in perspective. Although this part is quite general, it emphasizes those aspectsof monetary policy that are relevant for Iceland (the roles of capital controls andcurrency intervention, for example). Part Two, on the other hand, is an evaluation of
the Central Bank of Iceland own assessment of its policy making during the last eight
years or so. This evaluation draws on a number of reports published by the Bank, aswell as on interviews in Reykjavík with a number of Bank officials, government
functionaries, and experts from the private sector, including unions and businessgroups. It also relies on a deep analysis of the data. Part Three includes myrecommendations. There is also an Annex, where I discuss models for assessing
exchange rate equilibrium; this Annex is an integral part of the report, as it deals at aconceptual level with an issue that is of great importance for Iceland.

3.

One of the main objectives of Part Three is to provide suggestions that will help
improve monetary policy in Iceland. These recommendations have to do with the typeof information that is gathered and used in the decision-making process, as well aswith the type of models and processes used by the Central Bank of Iceland. This isalso done in the Annex, where I argue that there is need to greatly increase the CBI’s
research and knowledge on the determinants of long run real exchange rateequilibrium, and on the sustainability of the external accounts. The importance of
these issues stem from the fact that in small open economies and a globalized world,This restriction was included in the “terms of reference” provided to the team of outside experts analyzing thisissue. This means that by ruling out one of the “corner solutions” – giving up the domestic currency – the analysis
necessarily will explore “interior solutions” and the other “corner”: full float.

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the nominal exchange rate provides the main transmission mechanism for monetary
policy. 2
4.

The main conclusion of my analysis is that monetary policy has contributed
significantly to Iceland’s recovery, and to the return of confidence. A review ofmonetary policy actions since 2012-2013 does not show any serious mistakes, or
steps in the wrong direction. This does not mean, however, that there should be nochanges/adjustment/reforms. In fact, there are a number of areas where policy could
and should be improved, and a number of areas where changes should be considered.
My recommendations for the future are summarized in the next numerals, and are
explained in detail in the report itself.

5.

The main recommendations for the future may be summarized as follows:a. It is important to realize that there is no “silver bullet” in terms of monetary
regime/policy. Central banking is an imperfect science.
b. Along similar lines, it is important to realize that there is a close connection
between the exchange rate regime and the monetary policy regime.
c. After analyzing the data and the current policy procedures, my conclusion is thatat the current time the best monetary regime for Iceland is “flexible inflation
targeting.” 3
d. Although this is monetary policy framework currently pursued in Iceland, myproposal is not a defense of the status quo. In fact, there are a number of areas
where the current framework for monetary policy could be improved on. In thatregard, my recommendation is that Iceland moves to what may the called an“improved inflation targeting” monetary policy regime.
e. The most important suggested reforms/changes/alterations to the current policy
framework are the following:

It is important to explain at the outset that this is not a criticism of the CBI’s research department. In fact, as
noted in the body of this report, the research department is extremely efficient and produces high quality work.
This is particularly impressive given its small size – a staff of 20 people. The purpose of these comments is to pointout those areas where additional research would be beneficial.
3
As noted below, in the body of the report, this analysis only considered options with a “currency of its own.” Theregimes discussed in the body of the report are: inflation targeting with floating exchange rate; inflation targetingwith currency bands.
2

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Controls on capital inflows: The remaining controls on capital inflows
should be lifted gradually. It is also recommended that, at least for someperiod of time, the reserve requirements are set at zero, which is different
from totally eliminating the policy. The medium-term objective is to haveno capital controls. This is the standard for advanced countries, andIceland should aim at it. Having said that, it is important to note thatmacro prudential regulations should be put in place and strengthened, inorder to make sure that speculative forces/flows don’t destabilize thedomestic banking sector. The CBI has been making good progress in thisrespect. This issue is being addressed in detail by Prof. Kristin Forbes, aspart of this overall evaluation exercise.
Reserve accumulation policy: It is suggested that the CBI continues tohave a reserves accumulation policy that will maintain the stock of foreign
assets at the central bank between 1.5 and 1.8 times IMF’s RAM.
Intervention in the currency market: Currently, the CBI tries to smooth(large) changes in the ISK. However, market participants believe that thedecision-making rule is not particularly clear or transparent; this adds
unnecessary noise to the system. It is recommended that the CBI considers
the experience of other countries with transparent intervention policies.
The case of New Zealand, with its so-called “traffic lights” intervention
policy, is particularly relevant for this discussion. This case is discussed indetail in the body of the report.
Policy interest rate differentials: Defining the “optimal” policy rate
differential between the CBI and the major central banks, such as theFederal Reserve or the European Central Bank, is beyond the scope of thisreport. However, it is clear that its current level, as of December 2017 –300 basis points with respect to the FED and 425 bps with respect to the
ECB –, is not an equilibrium one. It is important for the CBI to research
this issue, and define an equilibrium range for policy differentials thatreflect risk premia. The Bank’s views on the subject should be made clear
to market participants. The equilibrium differential will depend on what isdone with respect to the three previous recommendations: capital controls,
reserves accumulation, and currency intervention.
6.

In spite of being a small institution, the Central Bank of Iceland operates in a highly
professional way. It has a high quality research department; CBI professionals are5very active in international fora, and highly respected by their peers. In addition, theBank has developed a strong and highly professional process for dealing withprudential regulation. However, since the Icelandic economy has gone throughimportant structural changes since 2007, there are some areas where theunderstanding of the way in which the economy works seems to be somewhat out ofdate. 4 In particular, and as it is pointed out below, the knowledge about importantphenomena such as the “pass-through coefficients,” and the appropriate coefficientsfor the Taylor Rule appear to be outdated. Also, there is limited
information/knowledge on what is the most appropriate way of reacting to externalmonetary shocks, such as changes in the policy rate by the major central banks(Federal Reserve, ECB, and Bank of England). Thus, it is recommended that further
efforts are made to understand better the following phenomena (See Parts Two andThree of this report for details):

i.

The way in which changes in the policy rate affect the yield curve, bothfor nominal and inflation-adjusted interest rates. This is vitally importantin order to understand fully the transmission mechanism of monetary
policy, and to make sure that this is as effective as possible. Surprisingly,
there are no up to date estimates on this process. Existing preliminary
evidence suggests that this (traditional) transmission channel has become
weaker in Iceland during the last few years; this is also the case in othersmall open economies. 5ii.

The way in which changes in the policy rates affect the nominal exchange
rate, both bilateral and trade weighted. There are no updated quantitative
empirical estimates of the impact of policy changes affect the value of the
ISK. This is equally important as the previous points, since in many small
open economies the exchange rate has become the most importanttransmission channel from monetary policy to the rest of the economy. As
noted, what makes this issue particularly complex is that Iceland went

It is acknowledged that the research department makes efforts to update these coefficients. A key question,
however, and one that is not clear to this analyst, is whether the analyses available at the time this report was
written, completely capture the new structure of the economy. It should be noted that a particularly important
attempt at updating the analysis was released after this report was written. It is contained in Monetary Bulletin,
2018/2.
5This point has been made by the governor of the CBI. See Gudmundsson (2017).
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through a major structural change a few years ago. That is, econometricestimates would have to capture this “break point.”
iii.

A better and more precise understanding of the “pass-through” mechanism
is of essence for an effective monetary policy design in a small open
economy. Here, it is important to obtain precise information on the passthrough with respect to different price indexes (i.e. CPI, PPI, tradables,
non tradables, housing, other services). The reason for this is the same asin the two previous numerals.
Points (i) through (iii) are fundamentally important for any small open
economy. The reason is that, as noted in the body of the report, in these
economies the yield curve usually provides a weak transmission
mechanism for monetary policy. As a number of authors, central bankers,
and analysts have recently pointed out, in a globalized setting theexchange rate provides the main transmission channel. This is particularly
true for countries such as New Zealand, Australia, and Iceland.

iv.

It is important to understand better the way in which changes in policy
rates affect the housing market, both in terms of prices and quantities.
There is recent evidence suggesting that housing is one of the main driversof the business cycle. As a consequence of the tourism boom, this seems
to be particularly the case in Iceland.
A key recommendation of this report: The CBI should incorporate
developments in the housing market in a more formal way the into themonetary policy process; possibly, even into the formal policy rule. 6 The
housing sector is important both with respect to prices and quantities. In
terms of prices what matters is how rents (including imputed rent forowner occupied dwellings) impact the CPI, and, thus, actual inflation. But
prices are not the only pertinent variable related to housing; quantities arealso very important. As noted above, and as explained in detail in the bodyof the report, an increasing number of scholars have recently argued that
housing is one of the most important determinants of the business cycle. In
addition, in many small open economies speculative activities in thisNotice that I am using the word "possibly." This means that this is a tentative conclusion; no final
recommendation can be made for results from in-depth research are available.

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sector have been at the heart of the major financial and banking crises; thisis particularly the case when “housing frenzy” coincides with RER
overlauation. In this regard, it is important to recall Prof. Robert Aliber’s
remark about the profusion of construction cranes in Reykjavík in 2007.
v.

It is important to define more clearly the form – including the coefficientvalues – of the “Taylor rule” used to guide policy. 7 More generally, there
is a need for the CBI to assess whether it needs to incorporate additionalterms into the policy rule. As I point out in this report, recent research by anumber of scholars, including John Taylor and Richard Clarida, indicatethat under some conditions it is optimal for small open economy toincorporate the policy rate of the ECB and/or the Federal Reserve when
making decisions about their own policy stance. This allows for better
policy coordination. At the same time, by maintaining interest rate
differentials within a certain range, it avoids large exchange rate
movements that may result in RER misalignment.

vi.

There is a need to have a better understanding of when the real exchange
departs from its long run equilibrium value. Between 2012 and mid 2017
the króna went through a significant degree of appreciation. Although in
its latest Monetary Bulletin the CBI argues that the currency is close to its
long run equilibrium, other analysts are not convinced that this is indeed
the case. This is the message that emerges from the two most recent IMF
Article IV consultation reports. This is a very important issue; so much sothat I devote a complete annex to address it. 8

vii.

There is need for a more thorough understanding of external equilibrium,including the long run sustainable level of the NIIP and of the current
account balance. The changes in current account observed in Iceland havebeen so phenomenal, that an in-depth analysis is required in order tounderstand fully where the economy stands, and what the long run

In this report I use “Taylor rule” in a generic form, to refer to the quantitative formulation/rule used by monetary
authorities to guide (and only guide) their policy. That is, I don’t mean a restricted view of the equation developed
by John Taylor in 1993. Senior officials of the CBI have expressed, in private correspondence, that at every meetingof the MPC a very large number of policy rules (up to 72) are analyzed. Most of these rules are used as cross check,and to make sure that policy actions are based on a robust analysis.
8
In terms of the quantitative analysis, the IMF seems to be in broad agreement with the CBI. This does not meanthat new and deeper research on these issues would be redundant. It is still the view of this analyst that greater
efforts should be made in this area.
7

8sustainable equilibrium is. Having this knowledge is essential forundertaking monetary policy in an efficient way.
These two last points are intimately related. As is pointed out in the Annex
to this report, determining the sustainable long-run NIIP for a country
constitutes one of the most commonly used techniques for assessing
whether the real exchange rate is close to its long run equilibrium value.
As already noted, in small open economies with inflation targeting, theexchange rate is the key transmission mechanism for monetary policy.
This means that central banks not only have to be aware of the magnitude
and speed of the pass-through from exchange rates to prices, but also
should have a firm understanding of the equilibrium value of the realexchange rate at any moment in time. This is not an easy thing to do, as
explained in the Annex, but it is fundamentally important; the CBI should
invest time and effort in improving its models on RER equilibrium.
7.

The effectiveness of monetary policy depends on other institutions and policies. Thismeans that for the “improved inflation targeting” regime to contribute to growth andstability, it is necessary to consider reforms in a number of other policies. Althoughproviding a complete catalog of possible reforms is well beyond the scope of thisreport, the following areas have been identified as needing attention: (a) Labor
markets flexibility: Iceland has a highly centralized wage negotiation system, which
results in wage rate ratcheting, and in inflationary pressures. Reforming this process
and moving to a more stable wage negotiation system, that accomplishes similar real
wage results, at a much lower nominal wage levels is essential. The idea thatcirculates in some quarters, of adopting a “Scandinavian bargaining” regime makes
eminent sense, and should be pursued seriously and systematically. (b) Increasing
pension funds overseas investments: Pension funds have accumulated assets in excess
of 150% of GDP. This has put significant pressure on the local financial market, andinterest rates. Allowing for a greater percentage of investments abroad will alleviate
this problem. In addition, a greater degree of portfolio diversification is very positive
for the retirement system, as it reduces risks associated with local shocks. (c)Consistent and sustainable fiscal policy: The adoption of the “Organic Budget Law”
represents an important improvement in the nation’s efforts to achieve and maintainmacroeconomic stability with low inflation. This initiative, however, could be
improved on, through a clearer definition of the “cyclical” component of the fiscal
deficit, and the determination of a sustainable level of public debt into the future.

98.

The recommendations listed above cover the immediate concerns of Iceland.
However, the CBI should also think in the longer run, and consider what type ofissues may arise in the future. A particularly important question is what to do in the
future if the CBI faces the “zero lower bound” (ZLB) problem that has affected othercentral banks in advanced economies. Recently, the President of the New York
Federal Reserve has pointed out that given the ZLB problem, and the increased
probability that the global economy will face a slowdown there is a need to rethinkinflation targets. Although Iceland is far from getting to the zero bound in its policyrate, the CBI should still reflect about the problem, and study in detail the alternative
solutions being suggested by other central banks.

9.

A final point to be mentioned, even though it is outside of the purview of this report,
has to do with governance at the CBI. Overall the bank functions well, it has a clearly
determined organizational chart, and well-defined hierarchical lines. Two aspects of
the organization, however, deserve additional consideration. First, whether themembers of the MPC should be full-time in their positions. Many first-rate central
banks in small open economies have that system, and it seems to work well. There are
a number of reasons for this, including the need to ponder extensively when
undertaken monetary policy; in addition call a fully dedicated board remove
providing current framework for policy. (I should make very clear that I did not get
any inclination, during my visit to Iceland or during my exchanges with a number of
Icelandic citizens and/or people familiar with the country, of any situation that could
be construed, at the current moment, as one of conflict of interest.) The second issue
that deserves some consideration relates to the external members of the MPC. Should
they have greater support that would help them with their job? More specificquestions include: Should the external members have a small professional staff toassist them with in depth analyses of the monetary and macroeconomic conditions?
Should their remuneration be competitive enough as to allow them to devote most of
their time to the CBI? Should at least one of the external members of the MPC be aforeign national, who would have a broad view of economic challenges in Iceland?
All of these are important questions that deserve attention as the country moves
forward to a new phase in the conduct of monetary policy.

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INTRODUCTION

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Introduction and background
Iceland’s economic recovery has been impressive. Eight years after an almost complete
meltdown, the economy is thriving. Gross Domestic Product has almost gone back to its trend,
inflation is below 2% per annum, unemployment is 1.5%, and there is a sizeable current accountsurplus (approximately 6% of GDP). With the explosion of tourism, a new source of foreignexchange and income that is literally transforming the country has been found. In addition,
income distribution has once again moved towards historical levels; the Gini Coefficient is on its
way back to the low 0.20s. Many of the emergency measures undertaken in the aftermath of the2008 crisis have been dismantled, and the government is already thinking of doing away withsome of the remaining ones. 9
The assignment
The purpose of this report is to discuss alternatives for monetary policy in Iceland. The return to“normality” has prompted the authorities to ask whether the current framework for monetary
policy is adequate for a small very open economy with a currency of its own. At this stage theexercise is circumscribed to options that maintain the ISK as the national currency. It has been
deemed that, from a political point of view, alternatives that imply joining the Eurozone, or
unilaterally adopting another currency such as the Euro or the USD, are not viable.
The objective of this exercise, then, is evaluating the current monetary policy regime in Iceland,and determining if it needs to be changed, reformed, or adjusted. The only restriction of theanalysis is that the króna should be maintained as the national currency. Since monetary policy
does not operate in a vacuum, I have interpreted the assignment to include some comments on
the supporting policies and institutions that would make monetary policy more effective.
Before proceeding, it is useful to provide a brief historical perspective; this will allow us to put
the discussion that follows in the right context. Iceland obtained monetary autonomy by the endof World War I, when it achieved sovereignty from Denmark in 1918. 10 In 1920 the country
faced what would be the first of many currency crises. Icelanders responded to it byimplementing currency controls. Two years later, in 1922 a 23% devaluation of the króna
followed. Between 1925 and 1939 the króna was pegged to the British pound; from 1939 to 1949
it was pegged to the U.S. dollar. In 1931, at the time the United Kingdom abandoned the gold
standard and devalued sterling, Iceland once again resorted to exchange controls; their intensity
varied through the years, becoming more stringent during times of crises and during World War
II. In 1970 Iceland became a member of the European Free Trade Association (EFTA), and in
For references on the crisis see Jónsson, and Sigurgeirsson, (2017). Jónsson (2009), and the various reports by the
IMF, and in particular the Article IV Consultation documents.
10This was just before the demise of the Scandinavian Monetary Union.
9121994 it joined the European Economic Area (EEA). At the time, and as a condition for joining
the EEA, Iceland was required to lift exchange controls. This situation would last until 2008,
when the most recent crisis erupted, at which time controls were reintroduced. At the current
time there are controls on capital inflows for bond-related flows of a maturity of less of one year.
In 1970, after the collapse of the Bretton Woods system, Iceland adopted an adjustable peg withrespect to the USD; this policy lasted until 1974. Between that time and 1983, the degree of
flexibility of the exchange rate was somewhat increased and the country followed what the CBI
has described as a “managed float” policy aimed at targeting the exchange rate. At first it was
targeted relative to the USD and then relative to various currency baskets. Between 1984 and1989 the exchange rate policy became more rigid. However, since inflation didn’t subside, small
devaluations – ten overall – were engineered; for all practical purposes the country wasfollowing a variation of a “crawling peg” regime. Between 1990 and 1995 a renewed effort at
exchange rate stability was made, and several exchange rate bands were used. Initially, thereference point was given by a 17 currencies basket, and the band width was +/- minus 2.25%
relative to the benchmark.The basket was redefined in 1992; the USD was given an 18% weight,
the Japanese yen 6%, and the ECU 76%. The króna was devalued in 1992 and 1993. In 1996 thewidth of the band was increased to +/- 6%, and a new basket of 16 currencies was defined. From1996 through 2000 the currency was allowed to move freely within the band; in February 2000
the band was once again widened, this time to +/- 9% relative to the basket target. In 2001 theexchange rate target – or target zone – was eliminated and an inflation target was adopted. This
regime lasted until the 2008 crisis. This saga, then, may be summarized as follows: the ISK has
only floated freely from 2001-2008,a very tumultuous period.
Initial conditions
At the time of this writing, Iceland’s monetary policy may be described by the following
characteristics: (a) The CBI follows inflation targeting (a regime adopted in 2001); the target is2.5% per year. (b) There are controls to capital inflows in the form of “unremunerated reserves
requirements” for one year, for bonds-related transactions. (c) The CBI intervenes frequently andin a discretionary way in the currency market. 11 According to the monetary authorities theseinterventions are aimed at reducing exchange rate volatility, and not geared at defending aparticular level of the currency. Some – including by the IMF – have called this monetary regime“inflation targeting plus.”

In this report “discretionary” is used in a technical sense, and has no pejorative meaning. It is used in the
tradition of the “rules vs discretion” debate on monetary policy in the 1960s and 1970s. Milton Friedman andJames Tobin were some of the participants in this debate.

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Currently – December 2017 –, the CBI’s policy rate is 4.25%. This is high; indeed significantly
higher than in other commodity exporting countries. Figure 1 contains data on policy rates inmonetary and real terms for Australia, Canada, Chile, New Zealand, Norway, Sweden, the U.K.,
and Iceland in mid-October 2017. All of these countries have a currency of their own. The real
rates are calculated using year over year core inflation; these inflation rates are also presented in
Figure 1.

5432Policy Rate

1

Core Inflation

0

Real policy rate

-1
-2
-3
-4

Figure 1: Policy rates in Iceland and selected OECD countries (November 2017)
Source: Trading Economics

As may be seen, Iceland is very different from the comparison group; its nominal policy rate issignificantly higher. Notice that this is the case in spite of the fact that its core inflation is on the
low side – below 2%. 12 In real terms, Iceland’s policy rate is also significantly higher than thepolicy rate in the comparison group.
Moreover, in real terms, Iceland’s policy rate is higher than in Mexico and Turkey – the twolowest income OECD members, which are not shown in Figure 1. In addition, the CBI policy
rate is significantly higher than the policy rates in US and in the Eurozone – as of December
2017 the spreads were 300 and 425 basis points.

This comparison group is similar to the one used by the CBI. The main difference is that I have added Chile to the
list.

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Iceland high policy rate may be explained by the fact that the country has only recently began to
get out of a major crisis. It is still convalescent, and slowly returning to “normality.” Having said
that, the fact that the initial conditions under which this report is written are characterized by(very) high policy interest rates is important, and should be kept in mind throughout the analysis.
As a result of these very high policy rates there are large interest rate spreads along most of theyield curve between Iceland and other advanced countries. These spreads are important
determinants of the “carry trade,” and are possible thanks to the existence of unremunerated
reserve requirements. (See the report for a discussion on the effectiveness of these types ofcontrols).
In September 2017 the CBI published a document titled “Monetary policy based on inflation
targeting: Iceland’s experience since 2001 post crisis changes,” as Special Publication No. 11.
This very useful report analyzes in great detail the evolution of macroeconomic conditions in
Iceland since the adoption of inflation targeting in 2001. In many ways this is a self-evaluation ofmonetary policy undertaken by the CBI. It is candid, deep, and very well written. I will rely on it
and cite it frequently throughout this report. 13 The most important point made in the September
2017 CBI’s report is that there was a structural break in monetary policy and macroeconomic
behavior around 2010–2012. While monetary policy was ineffective during the first sub period –a sub period that led to the 2008 crisis –, it has greatly improved in terms of efficiency andeffectiveness since then.
The CBI’s report bases its conclusion of increased efficiency of monetary policy on the fact thatduring the last three years inflation has been at, or below, the target, and that inflation and otherkey macroeconomic variables have experienced reduced volatility. However, as the document
points out, the reduction in inflation and volatility is, at least partially, the result of changing
international conditions – very low global inflation and a major drop in commodity prices –, andof currency appreciation. An important question, then, is whether this improved performance is(mostly) the result of a more effective monetary policy, or if it is (largely) a consequence of more
propitious international conditions. 14
On its November 15 2017, meeting, the Monetary Policy Committee of the CBI decided tomaintain the policy rate at 4.25%. The MPC’s statement declared the following:“There are indications that the output gap may have peaked. Significant demandpressures remain, however, which calls for a tight monetary stance so as to ensure
It is useful to read this CBI document it in conjunction with Governor Már Gudmundsson’s 2016 article “Global
financial integration and central-bank policies in small open economies,” as well as several issues of the Bank’s
Monetary Bulletin, and some of its Working Papers.
14
Clearly both types of forces have been at play. The challenge is to assess the extent to which greater
effectiveness in monetary policy was behind these13

15

medium-term price stability. Reduced demand pressures and an improved
inflation outlook are consistent with the MPC’s expectations in October, and theBank’s real rate is broadly as it was after the October interest rate decision. The
current monetary stance appears sufficient at present to keep inflation broadly attarget. Whether this turns out to be the case in the coming term will depend on
economic developments, including fiscal policy and the results of wage
settlements.”
The report
The rest of the report is divided into four main sections:
Part One deals with monetary policy options at a conceptual level, with particular reference tothe case of Iceland. This section is rather general, and deals with economic principles related to
exchange rates and monetary policy. It does not pretend to be a “primer” on macroeconomics,
and thus it moves at a rather rapid clip; also, it has a selective coverage, touching in greater detailon those issues that are of relevance for Iceland, while not delving onto those that are peripheral.
Readers interested in a more detailed conceptual analysis should consult the literature cited inthis part of the report, or many of the first rate textbooks for graduate students available in
English.
Part Two, on the other hand, is an evaluation of the Central Bank of Iceland own assessment of
its policy making during the last eight years or so. This evaluation draws on a score of reports
published by the Bank, as well as on interviews in Reykjavík with a number of Bank officials,
government functionaries, and experts from the private sector, including unions, and businessgroups. It also draws on a detailed analysis of Iceland’s macroeconomic and monetary data.
Part Three includes the conclusions and policy recommendations. These are divided into twogroups: recommendations regarding the monetary policy regime, including improvements andadjustments to the current policy stands, and recommendations on the type of models andinformation that the Central Bank of Iceland should incorporate into its tools kit. These latterrecommendations are based on the fact that at the current time, and mostly as a consequence ofthe significant structural changes experienced by the Icelandic economy, some of the CBI’smodels and policy tools appear to be somewhat out of date. This section also deals, briefly, withsupporting policies, including fiscal and the wage rate negotiation framework.
The report also includes an Annex where I discuss the different approaches used in theeconomics profession in efforts to calculate the long run equilibrium value for the real exchange
rate. It is fundamental for central banks to have reliable models of this type in order to undertake
monetary policy effectively. I argue in this Annex that this is particularly important for the case16of Iceland. This is because of the very significant structural changes that the country has gone
through. In particular, the move from a current account deficit of the order of 25% of GDP, to alarge current account surplus (around 6% of GDP) is very significant and unprecedented inmodern economic history of advanced nations. Equally impressive and unprecedented is thechange in the country’s NIIP position, in just eight years, from a negative level equivalent to125% of GDP, to a slightly positive level.

17PART ONE:MONETARY POLICY OPTIONS: REFLECTIONS BASED ON ICELAND

18

I.

Introduction: Iceland’s Recovery and the future

Iceland’s recovery from the 2008 crisis has been impressive. Growth has been vigorous, inflationis under control, unemployment is below 2%, and the external accounts are in surplus. In the lastyear, and in an effort to normalize the situation further, capital controls have been relaxed.
Controls on outflows were eliminated and, as a precautionary motive, the authorities maintained
controls on inflows, in the form of unremunerated reserve requirements of 40% on inflows ofless than one year.
As the crisis faded into the past, the authorities decided to engage on a review on monetary
policy in the country. At a broad level the question under consideration is what type of monetary
regime should Iceland have? At the current time the authorities have decided that the inquiry
should be restricted to monetary systems characterized by the country having a “currency of its
own.” For political reasons it is deemed that options that imply giving up the króna should not be
considered. In that regard, then, the notion of joining the Eurozone or unilaterally adopting
another convertible currency will not be considered in this report.
The double issue of the optimal monetary system and optimal exchange rate regime for Iceland
has been discussed many times in the past. These discussions have been prompted by recurrent
historical crises, and by the fact that for many years Iceland had a rate of inflation that greatly
exceeded that of most European countries and other advanced nations. The CBI published adetailed analysis in 2012, where the basic theoretical and conceptual principles behind theselection of the optimal monetary regime are explained in detail. 15
More than 25 years ago, in March of 1991, Paul Krugman wrote a report titled “Iceland
exchange rate regime: policy options.” Krugman points out that the purpose of his report is “toassess the factors bearing on Iceland’s future currency regime. In particular, should Iceland
maintain its traditional exchange rate flexibility, join the apparent European march towards
currency union, or seek a compromise solution?” (p. 2). Krugman’s report is divided into threeparts. He deals with the general principles of exchange rate regimes, and discusses the benefits
and cost of alternative currency arrangements. He points out that countries with unstable terms oftrade would, generally, benefit from flexible exchange rates. He also points out, along the lines
proposed by Mundell (1961), that the degree of labor mobility is key in determining theappropriate exchange rate regime. Krugman emphasizes the importance of two additional factors
in determining the optimal exchange rate/monetary system: the extent of wage rate flexibility,
and the existence (or absence) of indexation. Countries with greater degree of wage flexibility
could adopt more rigid exchange rates, while countries with wage indexation would experience
The review presented by the CBI is very complete, and solid. Readers interested in details should read it. I will
not repeat the arguments presented in that report.
15

19

situations where currency adjustments would be self-defeating. Finally, he points out that thedegree of capital mobility is also important, although the direction in which it affects theselection of the optimal regime is ambiguous. In spite of the fact that Krugman’s report is written
in a cautious tone, his recommendation at the time was that Iceland should have maintained its
currency and adopt an exchange rate regime characterized by flexibility. This early report is agood historical antecedent for the current discussion on the future of monetary policy andexchange rates in Iceland.
II.

Monetary policy in a small open economy:
Basic principles and the case of Iceland

In this Section I present a summary of the relation between exchange rate regimes and monetary
policy. This discussion is conceptual, brief, and to the point; it does not pretend to be a primer onmonetary policy. Authors interested in details should consult any of the graduates next inmonetary policy, such as Obstfeld and Rogoff (1995), or the 2012 CBI report on the connection
between the monetary regimes and exchange-rate systems.
a. Dilemmas, trilemmas, and all of that
One of the basic principles of macroeconomics is that monetary policy options are closely anddirectly linked to the exchange rate regime. The clearest manifestation of this connection is givenby the so called “trilemma,” sometimes also known as “the impossibility of the Holy Trinity”:“It is not possible to simultaneously have capital mobility, fixed exchange rates
and an independent monetary policy.”
This means that in countries with these characteristics the money supply is endogenous. Under
fixed exchange rates and free capital mobility, the country will import inflation from the rest of
the world. In this case, the nominal quantity of money in the country will be endogenous; it will
be adjusted through the balance of payments, and changes in the country’s stock of international
reserves.
As noted by Krugman in his 1991 report on Iceland, and by the Central Bank of Iceland in its
2012 analysis, the discussion on the appropriate exchange rate for a particular country is related
to what economists call the “optimal currency areas” discussion. This literature has emphasized anumber of “conditions” required for a country/region to be part of a particular monetary union.
As Robert Mundell (1961) pointed out in his original contribution to this discussion, the mostimportant prerequisite for being part of an optimal currency area has to do with factor mobility.

20

It was indeed this consideration which led Mundell to state that the optimal currency area is “theregion.” 16
In the aftermath of the 2008 global financial crisis there was renewed interest in the topic. A
number of authors asked whether the euro zone was, indeed, an optimal currency area. The main
conclusion of these analyses is that one of the failures of the euro zone was the absence of acommon fiscal policy, and of a broad financial safety net that covered all countries equally. As
Paul Krugman pointed out almost three decades ago, it is doubtful that Iceland satisfies thefundamental requirements to become a bona fide member of the euro zone. 17
b. Credibility vs. flexibility
In the late 1970s, and partially motivated by the work of Robert Barro and David Gordon, theoptimal exchange rate and monetary regime literature focused on the trade-off between“credibility and flexibility.” 18
According to this literature, governments that have discretion to adjust the value of the nominal
exchange rate will tend to abuse this power, introducing an inflationary bias into the economy.
At the heart of this issue is the fact that the Central Bank and the public – including the unions –play a strategic game that has a “time inconsistent” equilibrium. The central bank’s promises ofmaintaining a stable currency value are not “credible” and, as a result of this, the public behaves
as if these assurances will be reneged on. Wages and prices are hiked and the central bank ends
up validating these inflationary pressures.
Within this set up, countries that can “credibly” fix their exchange rate to a stable currency (or,in principle, to gold) will be able to escape this “time inconsistency” problem, and move to a low
inflation equilibrium. In this case, the central bank will import world inflation.
The problem with this approach, however, is that under most circumstances the public will be
suspicious of a simple currency peg. It will tend to see it as having an “escape clause.” Thismeans that the public will believe that there is an unwritten contract between the authorities andthe citizens that states that, if needed, the exchange rate peg will be altered through some kind of
mechanism (usually at stepwise devaluation). If the contingencies under which the “escapeclause” is to be used are perceived as being permissive, the commitment provided by the fixedexchange rate will be weak, and credibility will also be low. In this case inflation will tend to behigher than under a credible anchor.
Later, when he became an advocate for rigidly fixed rates with respect to gold, Mundell said that the optimalcurrency area was "the world."
17
This is so in spite of the fact that during the recent years there has been an increase in the degree of labor
between Iceland and continental Europe.
18
Of course, this type of analysis was also influenced by work by Prescott and Calvo.
16

21

The history of Iceland is replete with cases where such an “escape clause” was used, and as aresult of this the country ended up with an inflationary equilibrium that exceeded that of its peersin the advanced world. As noted above, after the collapse of Bretton Woods system in the early
1970s, Iceland followed a crawling peg policy which led to a double digit inflation. 19 However,in 1989 Iceland pegged the ISK to a basket of currencies (de facto the D-mark) in order to“import credibility” –inflation went down from 20-30% to about 2-3% in a three year period
1991-1992. It is possible to argue that this was one of the most of most successful exchange rate
based stabilization program in the immediate post Bretton Woods period; it was supported byincomes policies, including a general wage freeze and capital controls – which were thenliberalized in 1994. 20 The exchange rate peg, however, became unsustainable, and burst in 2001,
after the economy had overheated significantly and capital flows reversed; by 2000 the trade
deficit had reached 10% of GDP. An open question is whether the peg collapsed at the time
because the authorities failed to provide the required fiscal support in the form of countercyclicalfiscal policy. 21
At the end of the road, and to an important extent, the issue is an empirical one: what does theevidence say with respect to fixed exchange rates as a mechanism for constraining, ex ante, fiscal
and monetary policy, and thus providing a credible anchor? Is the fixed exchange rate a usefuland effective tool for providing credibility?
In other words, the key empirical question is how countries with pegged exchange rates have
performed relative to nations with alternative arrangements. A common mistake in this type ofanalyses is to compare countries that have successfully maintained a fixed exchange rate for a
prolonged period of time with other nations. The problem with that approach is that it is subject
to a serious “survival bias,” since only countries that sustained the peg for many years – that is,
those countries that avoided crises – are incorporated into the “fixed exchange rate” sample. Inthat regards, the way to proceed is to classify countries according to some “initial” exchange rate
regime, and include in the “peg exchange rate” category all countries that manifested the“intention” of having such a regime. This methodology, for instance, has been used recently by
Alesina and Wagner (2006). In an early attempt at evaluating the performance under alternative
exchange rate and monetary systems, Edwards (1992) analyzed empirically the historicalbehavior of over 60 countries using this procedure. His results indicate that the credibility
constraint introduced by a fixed exchange rate with an “escape clause” is limited, and depends
directly on the country’s inflationary history. Countries with a history of high inflation are
It was at the end of this period that Paul Krugman wrote his report on Iceland.
Mar Gudmundsson, the current governor, was instrumental in designing this policy. See
https://www.sedlabanki.is/uploads/files/WP-1.pdf
21
That was indeed the case in Argentina, where the experiment with a (semi) hard peg in the form of a currencyboard failed because the government failed to put in place the required countercyclical policies.
19
20

22

perceived of having abused the “escape clause,” and are less successful in using the exchange
rate as a commitment devise. This suggests that in the case of Iceland, or similar countries with ahistory of relatively high inflation, the pre-commitment technology provided by a unilateral peg
is likely to be limited.
An important question – and one that is somewhat outside the realm of the current report – iswhether countries with “hard pegs” are able to get around the problem generated by the implicit
existence of an “escape clause.” By hard peg, this literature means countries that have either acurrency board, or use another nation’s currency as their own. The empirical literature suggeststhat these countries indeed have had a lower inflation rate than nations with either flexible
exchange rate or with “soft pegs.” However, nations with extreme rigidity have also experienced
higher degree of volatility of GDP, and lower long-term economic growth. See, for example, thediscussion in Edwards and Magendzo (2003) and the literature cited therein.
During the 1980s and the first half of the 1990s some authors argued that exchange rate regimes
with “limited flexibility” provided an adequate solution for small open economies. These
regimes were characterized by bands, crawling pegs, and other type of fixed-but-adjustableexchange rate system. It was thought that by combining fixity with flexibility it was possible toacquire the best features of each of these two policy arrangements. These types of systems were
implemented in Latin America, East Asia, and in the countries of the former Soviet bloc.
Perhaps the most popular of these regimes was the “crawling peg,” where the nominal exchange
rate was fixed by the monetary authority, but adjusted periodically according to some implicit or
explicit rule. The most frequent variant was one where the authorities adjusted frequently(sometimes daily) the nominal exchange rate value according to inflation rate differentials
between the domestic country and a predetermined group of foreign nations.
By its nature, the main purpose of this type of regime – which at some point was also adopted in
Israel – was to avoid real exchange rate appreciation in countries with a domestic rate of inflationin excess of that of their trading partners. With time, however, it was found that these systems
tended to de-stabilize the macroeconomy, and introduce a significant degree of persistence into
the inflation-wage system. In some cases, it was found that countries that had adopted this typeof intermediate regime were moving dangerously close to completely losing their nominal
anchor. 22 As a result, intermediate regimes have lost adepts during the last few years. They do
not provide a credible anchor, nor do they allow real shocks to be efficiently accommodated. Inthat regard, then, they seem to be in the worst of worlds.

22

Edwards (1992).

23

c. Does flexibility really means having a shock absorber?
According to the “credibility versus flexibility” analysis, flexible exchange rates are superior incases where real shocks coming from abroad are dominant. According to this view, flexible
exchange rates act as shock absorbers, as they allow the real exchange rate to move to a new
equilibrium much faster than if alternative regimes are in place. This result is quite
straightforward, and is obtained in a variety of models, ranging from real business cycles tosimple stylized neo-Keynesian models. See Fischer (2001).
In most models of open economies, real external shocks – including terms of trade and realinterest rate shocks – will result in alterations in the equilibrium real exchange rate. 23 If thenominal exchange rate is fixed, the adjustment in the equilibrium RER will have to take placethrough changes in domestic nominal prices and nominal wages. As Nobel laureate James Meade(1951, p.201-02) argued early on, this adjustment will be difficult in countries with fixedexchange rate and inflexible money wages. According to Meade, in the presence of these wage
rigidities the economy is likely to benefit from what he called a “variable exchange rate” regime(what is known today as a flexible/floating exchange rate). However, Meade was careful to notethat flexible exchange rates are not a panacea, and that there are circumstances when they may
not help to accommodate external disturbances. This would be the case, for instance, if due toindexation or other mechanisms real wages are inflexible. This would also be the case if fiscal
policy does not accompany monetary policy, or if fiscal policy tends to work in a pro cyclicalfashion.
At the end of the road, and as is often the case in monetary economics, the benefits of flexible
exchange rates is an empirical issue. An early problem faced by researchers who tried to elicit ananswer to this query was that the classification of countries into different exchange rate regimes
was rather arbitrary, and did not correspond to reality. Indeed, the International Monetary Fundused a classification based on self-assessment; each country declared what type of regime it had,
without the IMF opining on whether that classification was correct or not. In the early 2000’s,
however, a number of researchers decided to create reliable indicators of countries exchange rate
regimes that captured the “true” nature of the currency/monetary system. The better-known
effort in this direction was undertaken by Levy-Yeyati and Sturzenegger (2002); work along
similar lines was undertaken by Carmen Reinhart and Ken Rogoff.
A number of recent studies using a de facto and “true” exchange rates the regime classification
system, have concluded that countries with more flexible exchange rates had indeed been able toaccommodate better terms of trade shocks. For example, Edwards and Levy Yeyati (2005)
developed a model of long-term growth that included the effects of terms of trade and other real
23

Edwards (1989). Obstfeld and Rogoff (1995).

24

disturbances. They estimated their model using a two-step treatment procedure. Their results,
which have been replicated and extended by other researchers, indicate that countries that facevolatile international prices for their exports and imports tend to do better when they have a more
flexible exchange rate regime. This research supports empirically and historically the notion thatflexible exchange rates have tended to act as shock absorbers. The differences in long-term
consequences are significant across regimes: the negative effect of the terms of trade shock on
growth was about one half under flexible rates, as compared to hard pegs. Other studies along
these lines, which have obtained similar results, include Aghion et al (2009), and Eichengreen(2007).
d. The transmission mechanisms of monetary policy under flexible exchange rates
The traditional transmission mechanism of monetary policy under flexible exchange rates andinflation targeting is the yield curve – see any model in the Mundell-Fleming tradition. The
central-bank changes the policy rate – usually a very short-term interbank rate – with the
expectation that that change will be transmitted along the yield curve, and will affect longer-term
interest rates, which, in turn, will impact consumption decisions by households and investment
decisions by firms. In the case of the United States, the expectation is that changes in the Federal
Funds rate will be reflected in the 10-year Treasury note yield. It is this longer-term benchmark
rate the one that affects economic agents’ expenditure decisions, including households’
expenditure in big ticket items. In discussing the transmission mechanisms of monetary policy,
Leamer (2015) has recently argued that the most important effect of changes in the long interest
rate is on the housing sector -- for an expansion of Leamer’s views see Part Two below.
For some time now – approximately since the first decade of the 21st century – there has been
concern among experts that monetary policy in the U.S. – and in other advanced
countries/monetary unions, for that matter – has lost effectiveness and power. Long-term interest
rates seem to be much less responsive to changes in the policy rate. Perhaps the clearest
manifestation of this phenomenon happened after July 2004 in the United States. Starting in thatmonth, the Federal Reserve hiked its policy rate by 425 basis points. However, the longer-term
rate (10-year Treasuries) did not change, or changed very little. This is what then Chairman Alan
Greenspan referred to as the “conundrum.” The most common explanation for this phenomenon
is that in a globalized economy with interconnected financial markets, longer-term interest rates
are determined by the global interaction between savings and investments, and are notsusceptible to being influenced by domestic monetary policy, not even by large countries’ central
banks. This view came to be known as the “savings glut” perspective, and was proposed anddefended strongly by Ben Bernanke.

25This point has been acknowledged by a number of central bankers. For example, in a 2016
presentation made at a conference in Singapore, CBI’s Governor Már Gudmundsson argued,
persuasively, that the traditional interest rate transmission mechanism is weakened (or broken) inopen economies in the 21st century. This is particularly so if the country in question is verysmall, as is the case of Iceland, New Zealand, Thailand, Chile, and other similar nations.
Governor Gudmundsson argues that under these open economy circumstances the main
mechanism of transmission ceases to be the yield curve, and it is replaced by the nominal
exchange rate.
This “exchange rate” transmission mechanism works as follows: a hike in the central-bankpolicy rate will generate, through the “carry trade,” an exchange rate appreciation. The stronger
currency, in turn, will generate downward pressure on prices – through some version of the lawof one price for tradable goods –, and in this way will reduce the inflationary pressure in thedomestic economy. Likewise, a reduction in the policy rate will prompt a currency depreciation,and through this mechanism, will generate upward pressure on prices. In addition, currency
depreciation will result in export expansion and an increase in domestic activity. Changes inforeign central banks policy rates will also have an impact on the value of the domestic currency:a hike in international interest rates generated by Federal Funds rate increase by the Federal
Reserve, will tend to depreciate the small countries currency, and through this channel impact on
domestic prices.
In order to understand fully the transmission mechanism through exchange rate channels, it isimportant to have models able to answer two questions: (1) what is the impact of changes indomestic (and foreign) policy interest rates on the exchange rate (both bilateral and multilateral)
and, (2) what is the “pass through” coefficient that translates changes in the exchange rate intochanges in domestic inflation. I address these two issues from Iceland’s perspective in Part Twoof this report.
To the extent that monetary policy is, indeed, transmitted through exchange rate changes, it isnatural that the central bank in a small open economy will take the exchange rate into account –either directly or indirectly –, when formulating policy. In particular, central bankers should beconcerned whether the real exchange rate is close to equilibrium, or if it is misaligned. If a
country is facing misalignment, monetary policy actions triggered by inflation considerations
may exacerbate this disequilibrium. This means, that there are reasons other than “fear of
floating” for central bankers to worry about exchange rates – see Calvo and Reinhart (2000) on
fear to float. I address some of these issues in Part Two of this report, as well as in the Annex
devoted to real exchange rate overvaluation.

26

e. Do flexible rates buy full monetary policy independence?
An important policy issue for small open economies with inflation targeting and flexible
exchange rates is how their central banks should react when advanced countries’ central banks(and, in particular, the Federal Reserve and/or the European Central Bank) change theirmonetary policy stance. According to traditional models of international macroeconomics (i.e.
the Mundell-Fleming model, in many of its versions), under flexible exchange rates countries areable to undertake independent monetary policies, and don’t face the “trilemma.”
That is, according to these traditional models, central banks in small open economies do not haveto follow (or even take into account) the policy position of the advanced nations, such as the U.S.
and the euro zone. More recently, however, some authors, including, in particular, Taylor (2007,2013, 2015), and Edwards (2012, 2015a, b) have argued that even under flexible exchange rates
there is significant policy interconnectedness across countries. In a highly globalized setting,even when there are no obvious traditional reasons for raising interest rates, some central banks
will follow the Fed. This phenomenon may be called “policy spillover,” and could be the resultof a number of factors, including the desire by central banks to protect domestic currencies from“excessive” volatility. If this is indeed the case, then even under flexible exchange rates there isno such a thing as true “monetary independence.”
The late Ron McKinnon from Stanford University captured this idea, when in May 2014, hestated at a conference held at the Hoover Institution that “there’s only one country that’s truly
independent and can set its monetary policy. That’s the United States.”
Of course, not every co-movement of policy rates should be labeled as “spillover.” It is possiblethat two countries (the U.S. and, say, Colombia) are reacting to a common shock—a largechange in the international price of oil, for example. “Spillover” would happen if after
controlling by those variables that usually enter into a central bank policy reaction function – thetraditional Taylor rule variables, say –, there is still evidence that the small central bank has
followed the Fed.
As Clarida (2014), Edwards (2016), Taylor (2015) and others have recently argued, there are atleast two reasons why it may be optimal for central banks in small economies to include theinterest rate in advanced countries central banks in their policy reaction function. 24 The first has
to do with what Calvo and Reinhart (2000) called “fear to float.” This phenomenon is usuallypresent in countries where there is significant currency mismatch in the banking sector. There isplenty of evidence from Latin America – Chile in 1982, Mexico in 1994, Argentina in the 2000s,
It should be noted that I am referring here to the direct inclusion of the foreign policy rate in the reaction
function. From early on it was understood that the exchange rate was part of any countries Taylor rule, as long as
there is not zero "passed through" coefficient.
24

27

for example – that indicates that due to currency mismatch large devaluations create havoc in thefinancial sector. If interest rate hikes by foreign central banks result in a (large) depreciation of
the domestic currency, it may be optimal for the domestic central bank to react by hiking its own
policy rate, as a way of avoiding the balance sheet effects of the depreciation in the context ofsignificant currency mismatches.
The second reason for “policy spillover” has to do with potential real exchange rate
misalignment. If currency “overvaluation” is costly – and there are many reasons why this is,indeed, the case –, then it may be optimal for the central bank to take misalignment underconsideration when undertaken monetary policy. For instance, it is possible that an increased
degree of overvaluation will generate export decline, and a large future output gap. This was thecase of Mexico during 20015-2017.
In a world with two countries, this situation is captured by the following two policy equations,where 𝑟𝑟𝑝𝑝 is the policy rate in the domestic country, 𝑟𝑟𝑝𝑝∗ is the policy rate in the foreign country,
and 𝑥𝑥 and 𝑥𝑥 ∗ are vectors with the traditional determinants of policy rates (the elements instandard Taylor rules, for example), such as deviations of inflation from their targets and thedeviation of the rate of unemployment from the “natural” rate:

(1)
(2)

𝑟𝑟𝑝𝑝 = 𝛼𝛼 + 𝛽𝛽𝑟𝑟𝑝𝑝∗ + 𝛾𝛾𝛾𝛾

𝑟𝑟𝑝𝑝∗ = 𝛼𝛼 ∗ + 𝛽𝛽 ∗ 𝑟𝑟𝑝𝑝 + 𝛾𝛾 ∗ 𝑥𝑥 ∗ .

In equilibrium, the monetary policy rate in each country will depend on the other country’s
rate. 25 For the domestic country the equilibrium policy rate is (there is an equivalent expression
for the foreign country):(3)

𝛼𝛼+ 𝛽𝛽𝛼𝛼∗

𝛾𝛾

𝛽𝛽𝛾𝛾∗

𝑟𝑟𝑝𝑝 = 1−𝛽𝛽𝛽𝛽∗ + �1−𝛽𝛽𝛽𝛽∗� 𝑥𝑥 + �1−𝛽𝛽𝛽𝛽∗� 𝑥𝑥 ∗ .

The stability condition is 𝛽𝛽𝛽𝛽 ∗ < 1. This means that in Figure 2 the P*P* schedule has to be steeper than the PP
schedule,
25

28

𝑟𝑟𝑝𝑝

P*P*

PP
B
A

𝑟𝑟𝑝𝑝∗

Figure 2: Policy rates equilibrium under “policy spillover” and large countries

Changes in the drivers of the foreign country’s policy interest rate, such as 𝛼𝛼 ∗ , 𝛽𝛽 ∗ , 𝛾𝛾 ∗ , or 𝑥𝑥 ∗ , will
have an effect on the domestic policy rate. This interdependence is illustrated in Figure 2, which
includes both reaction functions (1) and (2); PP is the policy function for the domestic country,
and P*P* for the foreign nation. The initial equilibrium is at point A. As may be seen, a higher
𝑥𝑥 ∗ (say the gap between the actual and target inflation rate in the foreign country), will result in ashift to the right of P*P* and in higher equilibrium policy rates in both countries; the new
equilibrium is given by B. 26 Notice that in this case the final increase in the foreign policy rate
gets amplified; it is larger than what was originally planned by the foreign central bank. The
extent of the effect of the foreign country’s policy move on the domestic country policy rate will
depend on the slopes of the two curves; these, in turn, depend on the parameters of equations (1)and (2).
Given the concerns that have emerged in central banks from around the world in the last few
years, it is possible to think that in some countries the actual policy rate would include other

The new equilibrium will be achieved through successive approximations, as in any model with reaction
functions of this type, where the stability condition is met.
26

29

global variables, including the “long” rate in the world economy (𝑟𝑟 ∗𝐿𝐿 )and the extent of
uncertainty in global financial markets (𝜇𝜇). In this case, equation (2) would become:(4)

𝑟𝑟𝑝𝑝 = 𝛼𝛼 + 𝛽𝛽𝑟𝑟𝑝𝑝∗ + 𝛾𝛾𝛾𝛾 + 𝛿𝛿𝑟𝑟 ∗𝐿𝐿 + 𝜃𝜃𝜃𝜃In a number of papers Edwards (2012, 2015, 2016) estimated these type of equations for a groupof small open economies in Latin America and Asia. His findings suggest that, indeed, there has
been “policies spillovers” in most of these countries. However, it is in the Latin American
nations – Chile, Colombia, and Mexico – where this phenomenon has been stronger during theperiod under study, 2000 – 2009. Similar results were obtained by Han and Wei (2016).
f. Capital controls and monetary policy
Capital controls have had a long history in modern currency crises. In most countries major andabrupt devaluations are preceded by a rapid decline in international reserves and massive capitalflight. 27 Countries often try to stop this process by imposing capital controls on outflows. The
empirical evidence indicates that, on their own, these types of capital controls tend to beineffective. Economic agents quickly find ways around them, and manage to continue moving
their funds out of the country in trouble. The most common way of circumventing these controls
is by under-invoicing exports and over-invoicing imports. At the same time, it has been foundthat the temporary imposition of controls may play a role in the short run, if they are part of acomprehensive stabilization program with other components related to monetary and fiscal
policies adjustment. 28
The imposition of capital controls was an important component of Iceland’s heterodox responseto the 2008 crisis. Today, most analysts agree that these controls – which were opposed at thetime by a number of analysts – played a key role in stopping the freefall, and eventuallystabilizing and launching a recovery of the economy. As noted above, the reason why thecontrols worked in Iceland is that they were a component of a broad and well-designed
comprehensive adjustment and recovery program. They were not, as it has usually been the case

The IMF has expressed its stance regarding capital controls in a number of publications on the "institutionalview." IMF (2016). The position taken by the IMF has been recently severely criticized by analysts such as John
Taylor, for being vague and for not recognizing that the final most desirable situation is one with capital mobility.
See, for example, the proceedings of the Hoover Institution 2018 conference on monetary policy.
28
Iceland after 2008 is an example of a nation where controls on outflows worked properly. The reason if that they
were part of a comprehensive – albeit heterodox – stabilization and adjustment plan.
27

30

in Latin America and other emerging regions, isolated measures merely aimed at stopping the
bleeding of international reserves.
Recently, the government of Iceland lifted capital controls on outflows. Icelandic nationals andcompanies are now allowed to rebalance their portfolios taking advantage of the existence ofinternational securities. At the time of this writing –December 2017/January 2018 – Iceland still
has controls on capital inflows, in the form of unremunerated reserves requirements (URR). This
type of capital controls was first implemented in Chile in the early 1990s, as a way of reducing
short-term “hot” capital inflows that were deemed to be speculative and disruptive. These typesof controls on inflows were later implemented in a number of countries, including Thailand(2006) and Colombia (2007). The controls on inflows that exist in Iceland exhibit somedifferences with respect to the Chilean case. In particular, in Iceland flows are subject to a
uniform reserve requirement, independently of maturity.
In Chile the percentage of the funds that had to be deposited as reserve requirements varied withthe maturity of the funds. Longer-term inflows were subject to lower requirements, and foreign
direct investment was free of such controls – in Iceland the URR rate is 40% and applies only forbond-related flows irrespective of maturity.
An important feature of this type of capital controls on inflows is that they act as a tax and, thus,
introduce a wedge between domestic and international interest rates. If the domestic interest rate
for a k-months investment is denoted by 𝑖𝑖𝑘𝑘 , and the implicit tax by 𝜇𝜇𝑘𝑘 , then it follows that (where
i is the international interest rate; in order to simplify the exposition risk premia issues are
assumed away):(5)

𝑖𝑖𝑘𝑘 = 𝑖𝑖 + 𝜇𝜇𝑘𝑘

Given the rate of the reserve requirement, it is possible to calculate the (approximate) tax
equivalent of these controls. Assume that the investor will keep his funds in the country for kmonths. Assume, further, that if k is lower that some maturity h, the investor needs to deposit afraction u of the funds in the central bank. Then, the tax equivalent to the URR is given by: 29

(6)

𝑢𝑢

ℎ

𝜇𝜇𝑘𝑘 ≈ 𝑖𝑖 �1−𝑢𝑢� �𝑘𝑘 �This ignores the presence of other taxes. In Chile, in fact there were other costs to foreign investors. See, forinstance, De Gregorio, Edwards, and Valdes (2000) for details.
29

31

In a paper that evaluated the effectiveness of Chile’s controls on inflows, De Gregorio, Edwards
and Valdés (2000) computed the tax equivalent of these URRs. For a maturity of one month thetax equivalent was 31%. It did decline rapidly for longer maturities, however. For instance, forsix months’ maturity the tax equivalent was slightly above 5%, and for a maturity of 12 months it
was only 2.6%.
In their empirical analysis these authors reached a number of conclusions that are relevant for
any country relying on controls on inflows, including Iceland. Their most important findings
may be summarized as follows: 30

30•

Because of the controls Chile was able to maintain a significant policy interest
rate differential with the rest of the world. More specifically these authors state
the following: “we only find a significant effect on the central bank interest rates,
which suggests that the URR was indeed used more intensely to accompany
monetary tightening.”•

The impact on longer term rates was not clear. It appeared that after 18 months’
maturity the effect was very small.

•

The effects of the URR on the RER were not conclusive, in the sense thatdifferent estimation techniques yielded different results. This let the authors tobelieve that using controls on inflows was not the best policy for dealing withshort-term real exchange rate appreciation. The authors pointed out that one of thepossible reasons for not finding much of a connection between the URR and the
RER was the existence, at the time, of an exchange rate band in Chile. (On theexchange rate band see the discussion below, in the section on currencyintervention).

•

The one thing that the URR did for sure was change the composition of flows,
reducing short-term flows and increasing longer-term ones. The total magnitudeof inflows aggregated across maturities, however, did not appear to change.

•

With time, market participants found large number of loopholes, reducing theeffectiveness of the capital controls.

•

One of the main reasons why capital controls were somewhat successful in Chile
was that they were supported by the right type of fiscal policy, which provided therequired overall credibility to macroeconomic policy in the country.

See, also, Edwards and Rigobon (2009).

32

It is important to note is that the positive effects, or benefits, of the URR should be compared tothe distortionary costs that they introduced in the form of a tax. One of the obvious consequencesof these taxes is that they may impact on the ability of certain firms to tap the capital market. The
controls result in higher domestic cost of capital. In a detailed analysis using data from the stock
exchange in Chile, Kristin Forbes (2007) found that the controls imposed a severe cost to smallerfirms. She concluded that as a consequence of the URR policy, smaller traded firms faced asignificant financing constraint, and had a higher shadow cost of capital than larger firms that
could circumvent the controls.
g. Currency intervention
As noted, one of the goals of capital controls has been to keep speculative flows in check, and inthat way reduce exchange rate volatility. Of course, capital controls are not the only tool which
may be used to moderate volatility; in addition, many central banks have used direct currencyintervention to achieve this goal. In some cases, including Chile in the 1990s, the two policies
coexisted. In this particular case, the URRs discussed above were accompanied by “exchange
rate bands.” The central bank was committed to intervening every time the currency hit one of
the bands. Throughout this period the exchange rate experienced significant forces towards
appreciation and, thus, the currency was mostly at the bottom of the band. See Figure 3 for theevolution of the exchange rate in Chile between 1991 and 1999.
An important inquiry is whether this type of combined policy – direct currency market
intervention, coupled with capital controls on inflows – is effective in reducing exchange rate
volatility. Notice that this combined policy exists currently in Iceland, making this question
particularly relevant for the current report.

33

Figure 3: Nominal exchange rate and bands in Chile, 1991 – 1999

From a purely technical point of view it is not straightforward to answer this question, since thetwo policies interact with each other in complex and highly nonlinear ways. In addition, theprobability distribution of exchange rate values is truncated at the bands. Edwards and Rigobon(2009) devised a two-step procedure to test the effectiveness of capital controls in thisenvironment. In the first step they computed a “shadow” exchange rate, which reflected market
forces beyond the bands. In the second step they investigated the way in which the controls
affected this “shadow exchange rate.” There results confirmed those obtained by otherresearchers, and suggested that a tightening of the controls on inflows were related to slight realexchange rate depreciation; that is, with the controls the RER was somewhat weaker than what it
would have been without the reserve requirements. In addition, it resulted in an increase in theunconditional variance of the nominal exchange rate, and a reduction of the vulnerability of theexchange rate to external shocks.
In 2013 the BIS published a book titled “Market volatility in foreign exchange intervention in
EMEs: What has changed?” Although this volume deals with the experiences of emerging
markets, many of the episodes discussed are of relevance, and provide some lessons, for
Iceland. 31 After examining 24 cases, the main conclusions of the analysis were that: 32
The volume reviews the cases of Brazil, Chile, Colombia, the Czech Republic, Hong Kong, Hungary, India,
Indonesia, Israel, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Saudi Arabia, Singapore, South
Africa, Thailand, Turkey, the United Arab Emirates, and Argentina.
32
BIS (2013), p.5.
3134“[E]xchange rate intervention needs to be consistent with the monetary policy
stance. Persistent one sided intervention, associated with sharp expansion ofcentral bank balance sheets creates risks for the economy.”
In addition, there was generalized agreement among the central bankers that participated in theconference that currency market intervention could be harmful if it precluded the real exchange
rate to move towards new equilibria. The report showed that most countries in this sample
intervened in the spot market, and that they preferred to maximize effectiveness by intervening
in an unannounced (and rather non transparent) fashion.
It is important to notice that an effective intervention policy requires that the central bank inquestion has some notion about the “appropriateness” of the real exchange rate at a particular
moment in time. That is, it is key that the central bank has an informed judgment on whether thecurrency is consistent with its “fundamentals.” This requires having appropriate and efficientmodels of real exchange rate behavior, an issue that I address in some detail in Part Two and in
the Annex to this report.
Currency market intervention is much less frequent in advanced nations. Among these, the most
relevant case is that of New Zealand, the pioneer country in the use of inflation targeting. In theyear 2004 the Reserve Bank of New Zealand announced a new policy of foreign exchange
market intervention. The purpose of this policy was to make corrections to currency values,
when these were clearly out of line with fundamentals. This policy was based on two key
provisions:•

it was to be very infrequent,•and it would be based on a transparent and well-known framework.

Since its inception this program has been used sparingly. Figure 4 contains data on intervention
since the program was launched in 2004, and through July 2017. As may be seen, the RBNZ
participated in the market infrequently, and when it did, and with possibly one exception, itbought and/or sold relatively small amounts of foreign currency. It is interesting to compare thisfigure to that of the Central Bank of Iceland’s intervention since 2014. In contrast to New
Zealand, Iceland frequently and massively since the year 2011 (see chart VII-40 in the CBI’s
Economic Indicators, September 2017; also see the discussion in Part Two of this report).

35

Net NZD purchased (sold) duringmonth (trade date basis) 3
1.000
500
0
-500
-1.000-1.500-2.000Figure 4: Exchange rate market intervention in New Zealand, 2004 – 2017

It is interesting to review, and to quote extensively what the RBNZ wrote about its intervention
policy. A first important aspect was to recognize that the objective of this policy is to alter thevalue of the currency; this is, the policy aimed at influencing the level of the New Zealand dollar.
In a paper published in 2004 the RBNZ stated (emphasis added):“Foreign exchange intervention… is the purchase or sale of New Zealand dollars
in exchange for foreign currencies…, with the objective of influencing the level ofthe exchange rate.”
In explaining this policy the RBNZ further declared that,“[T]here may be times when exchange rate fluctuations do not fully reflectfundamentals. Examples might include instances where the short run value of theexchange rate over or under shoots its ‘fair value’ because of non-fundamental
factors such as the trend following behavior implied by some ‘technical’ crateringrules followed by foreign exchange rate dealers, or other short-term speculative
behavior.” (RBNZ 2004, p. 2).
The Reserve Bank of New Zealand explains that there were two important requirements in orderto implement this intervention policy successfully. First, the Bank has to have sufficientinternational reserves in order to undertake the intervention, and it should be willing to live with
an open position in the foreign exchange market. Second, the RBNZ affirmed that it wasessential to have a firm and well-defined criterion for assessing the appropriateness of36intervention at any moment in time. According to the bank of these criteria were the following(these bullet points are a direct quote from the RBNZ):•“The exchange rate must be exceptionally high or low;•

the exchange rate must be unjustified by economic fundamentals;•

Intervention must be consistent with PTA [the inflation target]; and•conditions in market must be opportune and allow intervention a reasonablechance of success.”

One of these fundamental requirements is assessing whether “the exchange rate is exceptionallyhigh or low.” In this regards the RBNZ makes this very important point is that although, “theextreme rate could be exceptional by historical standards… it does not automatically follow thatthe level is unjustified.”
An important point made here -- and a point that I emphasize in Part Two of this report --, is theneed for central banks – including, of course, for the CBI – to have reliable models of realexchange rate behavior, in order to properly assess whether this fundamental relative price isclose to its equilibrium.
New Zealand’s intervention policy has often been referred to as a “traffic lights” system, withgreen, yellow, and red lights. One of its main features of this system is that the authorities
explain publicly their views about the exchange rate, and “warn” the market about possible
future interventions. Notice that “warning” is not the same as “announcing.” The RBNZ
“warns,” but does not “announce.” Indeed, in 2014 the Governor issued 13 warnings before
intervening. These warnings constitute the “yellow light” phase and often result in some market
reaction.
Before intervening the RBNZ’s governor usually states that he (and the staff) believes that thecurrency is out of line with fundamentals, and that if the situation persists the Bank will
“opportunely” intervene. The following quote from an October 2014 news analysis illustrates theway the system works. The quote deal with the the process that led to actual intervention on
Monday September 29, 2014: 33“The central bank quietly confirmed on Monday that it sold a net $NZ521 million
worth of the currency in August and had bolstered its foreign exchangeintervention capacity by $NZ938 million to $NZ9.558 billion…The confirmation
followed a detailed “final, final warning” statement from [Governor] Wheeler
last Thursday, that explained why the New Zealand dollar was extremely andhttps://bluenotes.anz.com/posts/2014/10/what-the-rba-can-learn-from-the-rbnz. Emphasis has been added.
Interestingly this article referred to lessons that Australia could learn from the Kiwi’s policy.
33

37

unjustifiably high and why intervention was being considered…The New Zealanddollar fell more than a cent on the news and has fallen more than four cents toaround US78c since [Governor] Wheeler's final warning last week…It's still earlydays, but Wheeler's second big intervention in his two years as Governor appears
to have been effective.”
In New Zealand, currency intervention has usually been consistent with monetary policy actions.
However, the two measures – selling NZD and changing the policy rate – are usually not
implemented at the same time. An acute observer of the New Zealand scene had this to say about
the 2014 intervention: 34[T]he Reserve Bank saw that currency intervention would not directly conflictwith a monetary policy tightening, as would have been the case between Marchand July when it was hiking the OCR…The RBNZ specifies the 'opportune-ness'of intervention as one of the 'traffic lights' it considers when intervening. The
more ‘opportune’ the moment, the more likely intervention will be effective.”
In order to be as transparent as possible, in the 2004 position paper the RBNZ described its
intervention framework by using the chart presented in Figure 5.A. The upper part of the graphdepicts exchange rate behavior: the red line is the actual currency RER index; the lower part,which includes the lien in blue, depicts the net international reserves position on the RBNZ.
In the upper part of Figure 5.A the horizontal black line is a de-trended measure of theequilibrium RER. The upper and lower dashed lines around the equilibrium define the zone ofnormal deviation from equilibrium; this is the “green traffic light” where the market is allowed tooperate without central bank interference. When the RER gets close to the dashed lines thesystem enters into the “yellow traffic light zone,” and the RBNZ states that it is becoming
concerned about the currency value. Once the actual RER crosses the dashed line the RBNZ
intervenes directly in the currency market by going short NZD and long foreign currency. This isreflected in the lower panel of Figure 5.A where the blue line corresponding to net international
reserves goes up, indicating reserves’ accumulation. Notice that accumulation is restricted to theinitial period when the real exchange rate is in the “intervention zone.” Further, once the realexchange rates is squarely back in the “green light zone” the RBNZ squares up, and international
reserves go back to the long term desired trend.
An important question is the expected effectiveness of this type of intervention in the currency
market. The RBNZ believes that under most circumstances by directly buying or selling foreign
currency it is able to temporarily impact the real exchange rate. Under intervention it will have a34

https://bluenotes.anz.com/posts/2014/10/what-the-rba-can-learn-from-the-rbnz. Emphasis added.

38

somewhat different behavior than in the absence of such intervention. This is illustrated in Figure
5.B, also taken from the RBNZ. In this figure the black horizontal line represents the long run
average real exchange rate obtained through a simple PPP calculation; the redline is the actual
exchange rate, while the blue dashed line represents the equilibrium real exchange rate that is
consistent with fundamentals. This figure captures two important points: first, the equilibrium
real exchange rate is not a constant number, and it can depart (at times, quite significantly) fromits long run PPP average. Market intervention of the type undertaken by the RBNZ and at themost expect to close the gap between the red and the blue dashed lines; that is the difference
between the actual and the equilibrium (fundamentalist determined) real exchange rate.

Figure 5.A: The mechanics of currency intervention in New Zealand39

Figure 5.B: RER behavior with and without RBNZ intervention

h. Monetary regimes, monetary policy, fiscal policy and labor markets
Robert Mundell was awarded the Nobel Prize for a number of contributions, including his
discussions in the early 1960s on the “effective policy assignment.” This work discussed how toassign different policy tools to different objectives. An important corollary of this analysis is thatthe “policy mix” is important. As noted, another Nobel laureate, James Meade, argued strongly
that the institutional arrangement of labor markets interacted in a very important way with theexchange rate regime and with monetary policy.
The lessons of these two eminent economists indicate that in order for monetary policy to beeffective, it has to be supported both by the appropriate fiscal policy as well as by the appropriatearrangement in labor markets. In particular, it is important for fiscal policy to be“countercyclical.” That is, during boom years the public sector should build up reserves, andduring lean or recession years it should use them up, in order to generate an expansion inaggregate demand. One of the greatest mistakes made by countries with “hard pegs” has been not
to have such countercyclical fiscal policies. The most recent example of this problem was inArgentina during the “convertibility law”. Between 1991 and 2001 Argentina had a currencyboard; the arrangement required that monetary expansion be backed by foreign exchange
reserves. However, the country pursued two policies that were in contradiction with the currencyboard. First, fiscal policy was clearly “pro cyclical.” Second, instead of being liberalized, labormarkets were regulated further. This meant that Argentina was left with no shock absorber to40

accommodate external disturbances. Starting in 1997, and as a result of the East Asian crisis
Argentina was hit by a number of severe external shocks, which greatly affected its degree ofcompetitiveness and its external sector and that eventually contributed to the crisis of 2001-02.
It is of essence, then, to consider both the fiscal and labor market when thinking and evaluating amonetary policy regime. In the case of Iceland the approval of the Organic Budget Law is an
important step forward. However, labor market negotiations continue to be based on a systemthat creates inertia and significant cost pressures. I deal with these two issues in Part Three of
this report.

41

PART TWO:
AN ASSESSMENT OF CURRENT MONETARY POLICY IN ICELAND

42

A. Introduction
The purpose of this part is to assess current monetary policy in Iceland. This is done in light ofthe basic principles discussed in the previous section. The discussion is based on an analysis ofsignificant bodies of data, the review of a large number of CBI documents, and interviews withcentral bank officials, academic economists, market participants, professionals in the financial
and banking sectors, members of Parliament, representative of the business sector, government
officials, and leaders in the unions sector.
B. The CBI’s September 2017 Report
The report “Monetary policy based on inflation targeting: Iceland’s experience since 2001 andpost-crisis changes, Special Publication No. 11” was published by the CBI in September 2017,as a contribution to the discussion on possible reforms and improvements to Iceland’s monetary
policy framework. This document, jointly with the quarterly Monetary Bulletin, and a number of
CBI working papers are the basis of the analysis presented in this report. Particular attention wasgiven to two prior CBI documents: Special Publication No. 6, and Special Publication No. 7. In
addition to this written material, I interviewed a number of people, as noted in the preceding
paragraph. I also analyzed in detail Iceland’s macroeconomic and monetary data.
The September 2017 report Special Publication No. 11 is a timely and well written document. It
provides a brief historical analysis, and an in-depth discussion of Iceland’s experience with
inflation targeting since 2001. The report is divided into seven chapters; it includes a large
number of informative graphs, and has a useful bibliography. The report correctly emphasizes
the role of inflationary expectations and inflation anchors.
The most important point made in the document is that there was a structural break in monetary
policy and macroeconomic behavior around 2010–2012. While monetary policy was rather
ineffective during the first sub period of the inflation targeting experience – a sub period that led
to the 2008 crisis –, it has greatly improved in terms of efficiency and effectiveness since then.
The main conclusions from this important report may be summarized by the following quotes
taken directly from the document published in September 2017 (emphases added). 35•“Inflation has been at or below the Central Banks inflation target for over three
years… Increased price stability has been achieved in spite of considerable domestic
inflationary pressures stemming from large pay increases, and this stability is due in

The 10 bullets that follow are quotes and may be found in pages 34 – 36 of the “Monetary policy based on
inflation targeting: Iceland’s experience since 2001 and post-crisis changes” report.

35

43

no small part to a steep decline in import prices, which in turn is due to domestic
inflation and the appreciation of the króna.”•“As inflation has fallen in recent years, it has also grown less volatile.”•“Deviations from the inflation target have also diminished greatly.”•“Short- and long-term inflation expectations have gradually subsided to the targets
and have become less volatile.”•“Inflation appears to be less persistent than before.”•“The inflation target has gained credibility.”•“Business cycle fluctuations have diminished.”•“Fluctuations in the exchange would have diminished… and there are signs that theircharacteristics have changed in recent years.”•“Exchange rate movement seemed increasingly to counteract the effects of aggregate
supply and demand shocks.”•“Fluctuations in real interest rates have diminished as inflation expectations havebecome more firmly anchored.”That is, the unmistakable conclusion that one draws from reading these quotes is that the CBIconsiders that in the last few years – since 2012, approximately – the inflation targeting approachhas worked (very) well in Iceland, and has helped achieve a number of important goals.
However, as the document points out, the reduction in inflation and volatility is, at least partially,
the result of changing international conditions and currency appreciation. An important question,
then, is to what extent this improved performance is the result of a more effective monetary
policy, and to what extent it is a consequence of more propitious international conditions. 36
Another way of phrasing this question is: How effective would monetary policy had been undera less favorable external environment?
In addition, the presence of controls on capital flows – on both inflows and outflows from 2008
to 2015, and on inflows since 2015 --, may have bolstered the “effectiveness” of monetary
policy. 37 By placing substantial amounts of “sand” in the wheels of capital markets, theauthorities have increased the CBI’s ability to operate in a way that is idenpendent ofinternational capital market conditions.

Clearly both types of forces have been at play. The challenge is to assess the extent to which greater
effectiveness in monetary policy was behind these37
it should be noted that the extent and target of capital controls changed in Iceland in a pragmatic way, and in aneffort to deal with the crisis. During the initial period the emphasis, of course, was on controlling capital outflows.
That is, there were no controls on inflows from October 2009 through June 2016.
36

44

Although, the CBI report covers a lot of terrain, some topics are addressed briefly, and there aresome omissions. In what follows I elaborate on these issues. The main objective of this
discussion is to signal areas for additional research that would help improve monetary policy
effectiveness in the future.
An in-depth analysis of the effectiveness of monetary policy requires information on a number ofissues which are only outlined in the report. Most of these issues have to do with four broadly
defined areas:(a) the transmission mechanism(s) of monetary policy;(b) optimal Taylor rule for small open economies such as Iceland;(c) the determinants of the equilibrium value of key macroeconomic variables,
including the real exchange rate;(d) the effectiveness of capital controls and currency market intervention.
As may be seen, many of these policy areas mirror the conceptual discussion presented in Part
One of this report. In what follows reference will be made to the different issues addressed
above.
C. Transmission mechanisms
C.1 Monetary policy and the yield curve
As noted in Part One of this report, the traditional transmission mechanism of monetary policy
under flexible exchange rates and inflation targeting is the yield curve. In a very straightforward
way, the degree of “effectiveness” of monetary policy may be measured through a two-stage
procedure:•First, to what extent do changes in the policy rate affect the longer-term
benchmark rates (both nominal and indexed);•

Second, to what extend do changes in this benchmark rate affect aggregate
expenditure, and in this way inflationary pressure.

A key issue in evaluating the “effectiveness” of monetary policy in Iceland is how these twoquestions are answered. Surprisingly the CBI’s report is rather scanty on this subject. It addresses
the connection between policy and longer term interest rates in section 6.1 (pages 28 and 29),
and their relationship is presented in Chart 6.2. In addition, there is also a rather lengthy footnote(footnote 25, page 28) with some technical discussion. However, there is no detailed presentationof the way in which the policy rate affects longer-term interest rates in Iceland (5 year Treasury

45bonds, for example), nor whether this relationship has changed through time (one suspects that ithas). This, in spite of the fact that the report emphasizes strongly – and correctly –the notion that
there has been a breakpoint in structural economic relationships in Iceland; mechanisms inoperation during the first few years of this century, do not work any longer. 38
The CBI undertook a study on the transmission of policy rates along the yield curve in the year
2001. 39 That study is interesting, and very professionally done. In the third issue of the Monetary
Bulletin of 2006, Appendix 1 is devoted to discussing the transmission mechanism of monetary
policy in general and in the case of Iceland in particular. However, as pointed out above and asemphasized in the September 2017 CBI report, there have been important changes in the
structural economic relations in Iceland. This means that there is need to update this type ofanalysis, in order to have greater clarity of the way in which changes in monetary policy affectthe key variables in the economy.

20
18
16
14
12
10
8
6
4
2
2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

CBI key interest rateRIKB 25 0612

Figure 6: Policy rate and long bond rate in Iceland, 2008-2017

As noted in Part One, a number of experts have argued that monetary policy in the U.S. has lost
effectiveness during the last few years. Changes in the Federal Funds rate are not transmitted into
In the traditional Mundell–Fleming model, under most circumstances domestic and foreign assets are imperfect
substitutes. In its graphical representation this means that the external sector equilibrium condition (the so called
FF curve) is represented by an upward sloped schedule. In this case the transmission mechanism includes both theinterest rate and the exchange rate. Notice that most analyses assume that currency depreciation is expansionary.
There are circumstances, however, where the opposite is true, and where depreciation is contractionary.
39
See, Petursson (2001).
38

46

longer rates in the same fashion as they did in the past. Central bankers such as Ben Bernanke
have pointed out that in a globalized economy with interconnected financial markets, longerterm interest rates are determined by the global interaction between savings and investments, andare not susceptible to being influenced by domestic policy, not even by large countries’ central
banks. In his 2016 article, Governor Már Gudmundsson recognizes this point, and makes a veryclear presentation of the way in which interest rates are determined in globalized economies. 40 In
order to illustrate the situation, in Figure 6 I show the evolution of the CBI’s policy rate and theyield on a long-term government bond (RIKB 25 0612) between the years 2008 and 2017; thesedata are weekly. As may be seen, there are periods through which these two interest rates moved
in the opposite direction. During the most recent circumstances – since late 2015 – they appear to
be moving with greater synchronicity. However, the overall lesson from this diagram – and from
econometric work -- is that if one takes the last 10 years, the relationship between the policy rate
and the longer-term interest rate is weak. This is confirmed by a number of regression analyses
using various techniques – not reported here due to space considerations. 41 Not surprisingly,
given the high-frequency nature of these data, the results also indicate that during this period
there was significant persistence in long-term interest rates. Figure 6 also shows some interestingdevelopments during the earlier post crisis years. As may be seen, between 2008 and mid 2010
the policy rate was above the long-term interest rate. This was possible because of the existenceof stiff capital controls.
The widespread use of indexation has also been a source of weak yield curve transmission.
Indeed, in Iceland there most mortgage loans – approximately 80% -- are indexed and have 40
year maturities. The existence of this widespread market represents a challenge for the CBI.
Changes in the policy rate will have limited impact on the housing and real estate markets.
In the mid-2000s, the “conundrum” situation described by Chairman Greenspan in the U.S. wasalso seen, although to a lesser extent, in Iceland. Between 2005 and 2007, the real CBI policy
rate went from 2% to almost 10%, while the real long-term rate merely increased by 100 basis
points, from 4% to 5%. Given the importance of the housing market, central banks with a limited
capacity to affect long term rates –as seems to be the case for the CBI --, should rely on othertools in order to ensure financial stability, and in particular in order to avoid the type of housing
frenzy that characterized many advanced economies in the period leading to the “GreatRecession.” These tools are part of “macro prudential” regulations and include measures as
determining maximum “loan to value ratios” in the mortgage market.

The question of the transmission mechanism goes back to, at least, the Mundell–Fleming model. See discussion
below.
41
In fact, in some of the error correction regressions the sign of the policy rate was slightly negative and marginallysignificant.
40

47Interestingly, the Reserve Bank of New Zealand instituted these types of housing market
regulations in October 2013. In November 2017 the RBNZ announced that it was easing the
LVR, starting on January 2018. It is illustrative to quote extensively from the Bank’s
communique from November 29 2017 (I return to the issue of the relationship between monetary
policy and the housing market below): 42“Domestically, LVR policies have been in place since 2013 to address financial
stability risks arising from rapid house price inflation and increasing household
debt. These policies have helped improve banking system resilience by
substantially reducing the share of high-LVR loans. Over the past six months,pressures in the housing market have continued to moderate due to the tighteningof LVR restrictions in October 2016, a more general firming of bank lending
standards and an increase in mortgage interest rates in early 2017.
“Housing market policies announced by the Government are also expected tohave a dampening effect on the housing market.
“In light of these developments, the Reserve Bank is undertaking a modest easingof the LVR restrictions. From 1 January 2018, the LVR restrictions will requirethat:•

No more than 15 percent (currently 10 percent) of each bank’s new
mortgage lending to owner occupiers can be at LVRs of more than 80
percent.

•

No more than 5 percent of each bank’s new mortgage lending toresidential property investors can be at LVRs of more than 65 percent(currently 60 percent).

“The Bank will monitor the impact of these changes and will only make further
LVR adjustments if financial stability risks remain contained. A cautious
approach will reduce the risk of resurgence in the housing market or deteriorationin lending standards.”
It is important for the CBI to continue to work on this subject, and to have a clearer sense of theextent to which the relationship between its policy rate and the longer-term benchmark rates haschanged. Without exaggerating, it may be argued that without that kind of knowledge it isdifficult to truly assess the degree of effectiveness of monetary policy.

42

https://www.rbnz.govt.nz/news/2017/11/reserve-bank-to-ease-lvr-restrictions

48

C.2 Monetary policy and the exchange rate
As mentioned in Part One of this report, a number of authors have argued that in open
economies, and in particular in small open economies, the exchange rate is the most importanttransmission mechanism of monetary policy. Short-term interest rates hikes generate a nominal
exchange rate appreciation, and through this mechanism, and some version of the “law of one
price,” a downward pressure on tradable goods’ prices.
The CBI September 2017 report addresses the connection between interest rates and exchange
rates throughout its argument on the different components of CPI inflation. The report makes theimportant distinction between housing inflation, and imported goods inflation (See, for example,
Chart 4.1, and the analysis in pages 16 – 17; see also Sections 5 and 6).
The discussion, however, is not undertaken within the context of “transmission mechanisms,” ormonetary policy effectiveness. For instance, there is no detailed information on the (expected)
magnitude of the impact of an interest rate hike on the value of the ISK, either in the short orlong run. It is recommended that the CBI addresses this question empirically, in order to evaluate
and improve the effectiveness of monetary policy. Further, an analysis of CBI reports and otherpublications provide limited information about this important relationship. 43
It should be noted, however, that this is a somewhat challenging exercise, given the fact that
Iceland has had capital controls, and that these have changed in intensity during the last few
years. 44 These changes in controls may have introduced structural breaks that are usuallydifficult to assess in a precise fashion. It is also difficult, since the international evidence
suggests that, although the nature of the relationship between short-term interest rates andcurrency values is well-established (higher rates tend to strengthen the domestic currency), themagnitudes of these effects are usually estimated in a very imprecise fashion. 45 In addition, there
are feedbacks from exchange rates expectations an interest rates.
However, to the extent that the nominal exchange rate provides the main transmission
mechanism for monetary policy, it is fundamentally important to have some kind of notion of the
There are numerous references to the problem in speeches by the CBI's governor, but would is missing istechnical work that would pin down the nature of this relationship within the context of the transmission
mechanism discussion.
44
Edwards and Rigobon (2009).
45
This has to do with the traditional difficulty in not rejecting the uncovered interest parity condition. Most
empirical studies that have attempted to analyze whether this arbitrage condition holds have ended up estimating
the corresponding coefficients in a very imprecise fashion.
43

49

quantitative relationship between monetary policy actions and changes in the exchange rate. The
point is this: a useful way of evaluating the effectiveness of monetary policy is using a two-stage
procedure similar to the one proposed above: in the first stage it is assessed the extent to whichmonetary policy affect the exchange rate – with other things given –, and in the second stage it isdetermined how exchange rate changes affect the inflation target. 46
Additional information is needed on the relationship between these key variables – policy rateand exchange rate – in order to assess fully the degree of effectiveness of monetary policy. Thisadditional information is of two types: (a) historical/empirical. That is, there is need for bettermeasures of the impact of changes in the policy rate on exchange rates (with other things given);and (b) doctrinal, in the sense understanding how the CBI views the interplay between these twovariables in its quest to fulfill its mandate.
C.3 Exchange rates and pass-throughAs noted above, and as emphasized in the literature – including in the article by Governor
Gudmundsson –, in small open economies the exchange rate provides one of the fundamental
transmission links for monetary policy. This means, as already mentioned, that in order to assess
its effectiveness it is necessary to have an approximate (and updated) notion of the “passthrough” coefficient, or the extent (in percentage terms) to which changes in the currency will
impact different price indices. The CBI has done some work on this subject in the past. For
example, 2011/3 issue of the Monetary Bulletin devotes a Box (VIII-1) to the subject. In this Box
the literature is reviewed, and different findings by different authors are confronted. It is argued
that after the crisis the pass-through coefficient in Iceland did not decline. Working Paper 14,
from 2001, by the CBI’s chief economist Dr. Pétursson also deals with this question. This is aninteresting and well-constructed paper, but it has not been updated, and its results correspond to adifferent era in Iceland’s economic history.
The CBI September 2017 report addresses the connection between currency values and inflation.
For example, on page 25 we read:“…currency appreciation also helps to keep domestic inflationary pressures undercontrol, and furthermore, it directly reduces inflation through lower importinflation. In the same manner, currency depreciation can mitigate a downturn.
Without exchange rate flexibility, business cycles could become more volatile, as
an important part of the economy’s shock absorbing capacity has been removed
and an important channel for monetary policy transmission to the real economy
has been closed off.”
46

See, for example, Edwards (2018a).

50

However, the term “pass-through” does not appear in the document, nor is there a discussion on
the quantitative effect of currency changes on the different inflationary indices. It is important to
notice that this kind of analysis should look in detail at different measures of inflation. The pointis a subtle but important one; in order for the exchange rate to be as successful and effective
shock absorber it should be able to accommodate required changes in the real exchange rate, or
relative price of tradable to nontradables. This means that it is desirable that nominal exchange
rate changes affect tradable goods, without impacting on prices for domestic goods. In otherwords, this means that in an ideal world currency depreciation would have a large impact on thedomestic price of tradables, while there would be no pass-through to nontradables goods. In thisway the nominal depreciation would be effective, in the sense of altering the real exchange ratein the desired direction. In a number of countries the pass-through coefficient is relatively high,and relatively similar for tradables and nontradables. 47 In this case, and for all practical purposes,“inflation targeting” becomes very similar to “exchange rate targeting.” The reason is thatchanges in the nominal exchange rate barely contribute to RER adjustments. At the same time,they result in high (across the board) changes in prices. 48
As noted above, the CBI has done a number of studies on this issue in the past. An interesting
contribution is the 2008 Working Paper titled “How hard can it be? Inflation control around theworld.” 49 This analysis suggests that the pass-through for Iceland is in the vicinity of 0.40.
However, as in other instances, the information in this particular paper seems to be outdated. As
noted above, and as the CBI itself has pointed out, there has been a structural break in economic
relationships in Iceland. In order to improve the conduct of monetary policy, and to have better
tools to assess its effectiveness, it is necessary to have new estimates of pass-throughcoefficients, for different price indices. In particular, it is important to have this information forthe housing component of the index.
C.4 Monetary policy and the housing sector
The September 2017 CBI report points out that the housing sector is fundamentally important in
Iceland. In particular, it is argued that the contribution of housing to inflation – via the imputed
rent of owner occupied dwellings – has been relatively high; See Chart 4.1, and the discussion inpages 16–17.
The deconstruction of inflation in different components, emphasizing the contribution of
housing, is correct and is welcomed. The following quote from the document is useful (page17):

Historically this has been especially the case in Latin American nations.
Edwards (2006, 2007).
49
Pétursson (2008).
47
48

51

“… inflation excluding housing has fallen very rapidly in the recent term. This
reflects the swift rising house prices in the recent past: for inflation including
housing to be close to the target it is clear the price of other goods and services
must rise modestly or even fall.”One could speculate that the surge in the tourist sector has been related to the rapid increase is in
housing prices. However, in order to have a clearer idea of these trends it is important toundertake detailed analyses of the dynamics of housing prices. This should be done in detail,distinguishing between different types of dwellings, and different parts of the country. As noted
below, however, it is not only important for close on housing prices, but also on construction andthe “quantity” aspect of the problem.
Recent research in other countries – and in particular in the United States – suggests that housing
is not only important as a determinant of inflation, but also as one of the main drivers of thebusiness cycle. Edward E. Leamer (2015) has even argued that “housing really is the businesscycle.” The point made by Leamer and other authors is that although housing is a relatively small
component of GDP, it has the important feature of being the most important large-ticket durable
in any economy. This means that economic agents can either accelerate or postpone in time thedecision to invest in new housing structures. If agents believe that interest rates will go up in the
future, they will build today more housing than what is “normal,” and in this way they will move
expenditure from the future into the present. This will tend to accelerate the boom during goodtimes, and make the slowdown more profound during bad times. According to Professor Leamer
there is a role for monetary policy here. He writes,“the only way to stop a durable cycle [driven by housing] is to intervene toprevent the stock from becoming excessive, which means high interest rates ofinterest when housing starts have been above the normal… for an extended periodof time.” 50
Leamer goes as far as arguing that monitoring the housing market (in terms of quantities) is
fundamental for a central bank. Although he does not state it explicitly, one could argue, basedon his analysis that central banks should have a specialized unit that monitors the behavior of the
housing sector, and follows both prices and construction activity. The cyclical movement of thesector, Leamer argues, should be a fundamental determinant of any decision to alter the policy
interest rate. 51
This amplifying effect of housing – or more generally the construction sector – in the businesscycle is possibly even more important in small open economies, where construction booms are
50
51

Leamer (2015), p. 5.
Recently the CBI has been looking at the housing market, including at the effect of AirBnb.

52

many times financed with foreign capital. In that regard, if the upswing in this sector goes handin hand with a current account deficit and a stiff currency appreciation – as was the case in
Iceland before the crisis –, the probability of a large disequilibrium situation is higher – this isrelated to what we can call the “Robert Aliber cranes index of disequilibrium.”
In light of this international evidence and discussion, it is recommended that the CBI undertakes
research along the lines suggested by Leamer, in order to understand truly the way in which thishousing channel operates in Iceland’s business cycle. It should be noted that according to
Leamer, policy changes are transmitted into the housing market through the term structure. This
raises the question of whether there is still a “housing cyclical effect” when the yield curve effectis weak, and when the exchange rate is the main transmission mechanism. It is possible, forinstance, that agents consider their net wealth position (partially) in foreign currency (dollars or
euros). If this is the case, we would still see the housing effect in economies where the exchange
rate is the main transmission mechanism. At the end of the road, this is an empirical issue, which
could/should be analyzed by the CBI.
In Iceland a significant fraction of construction project are financed by banks with short term or
revolving credit lines. 52 This makes the supply side sensitive to changes in monetary conditions.
High policy rates tend to restrict supply. On the other hand, most mortgages are 40 year loans
indexed loans, with fixed payments. This means that on the demand side monetary policy
conditions tend to be less important. This reinforces the need to have a better and more complete
understanding of the construction sector.
The above discussion suggests that in Iceland housing is particularly important, and that it shouldplay a prominent role in the CBI analysis of the macroeconomic situation and on the cnduct ofmonetary policy. An important question addressed below is whether the CBI should incorporatea “housing variable or index” as an additional variable in its policy rule.
D. Taylor rules for a small open economy
For some time now the Taylor rule has provided guidance to central bankers from around theworld. In the past, the CBI has done extensive work on the subject, and has referred to this rulein many of its publications and research papers. For example, this is done in the Monetary
Bulletin 2002 (2). In this publication it is argued that if a “strict Taylor rule” had been followed,
policy interest rates in Iceland should have been slightly higher between 2004 and 2007. The
Monetary Bulletin, 2013 (2) relies on a Taylor Rule analysis to explain why policy interest rates
are higher in Iceland than in other advanced nations. Also, Box I-2 of 2007/3 issue of Monetary
Bulletin is devoted to this problem.
Icelandic Chamber of Commerce (2017)

52

53

The CBI September 2017 report mentions this rule in various passages. The analysis isinteresting and professional. In particular, the discussion in section 5.2 is quite illuminating andclever. The document, however, does not get into the specifics of how the Taylor rule iscurrently used as a policy guide in Iceland. Moreover, the coefficients presented in the discussion(see, for example, page 24 of the September 2017 CBI report) are those originally used by Taylor
in his analysis of the U.S. economy. There is no reason, however, for these parameters – 0.5 and1.5 respectively -- to be the same across countries; indeed, it would be surprising if this is thecase. In this regard, what is always clear is that the coefficient of the deviations of inflation fromtarget should be greater than one. The reason for this, of course, is that it is necessary thatchanges in the policy rate stemming from changes in actual inflation are translated into realinterest rate changes. How much greater than one it should be, is a country specific issues thatcan only be answered after undertaking specific research.
In an important, and yet little read paper, John Taylor discussed how monetary rules should beapplied in small open economies without fully developed capital markets. 53 Taylor concluded
that if a country opted for a flexible exchange rate – as opposed to an exchange rate anchor --,using a Taylor rule was still the most effective way of conducting monetary policy. However, he
added that in these cases “may require modifications of the typical policy rule recommended for
economies with more developed financial markets.” In addition, Taylor insisted on a key point
which is often forgotten: the purpose of policy rules is to provide guidance to policy makers;
they are not to be followed mechanically.
An important question, as noted, is whether traditional policy rules with two terms (inflation andunemployment deviations) should be modified in small open economies. 54 Three specificquestions that are relevant for the case of Iceland arise. (1) Should housing prices and theexchange rate enter directly into the monetary rule, as additional terms? (2) Should foreign
central banks’ policy rates (FED and ECB, say) enter explicitly into the monetary rule asadditional terms? (3) What should be the coefficients of the traditional terms in the policy rule(another way of phrasing this, is how different should they be from the standard/historical rule?
Answering these queries in detail and in a precise way is beyond the scope of this report; doing it
for Iceland would require extensive econometric and modeling work. However, in what follows I
provide some reflections on some of these issues from Iceland’s perspective. Hopefully thesereflections will provide some guidance until more definitive evidence is available.
The first points to make is that simple and traditional two-terms monetary policy rules -- withdeviations of inflation from target, and deviations of real activity from full employment – already
53
54

Taylor (2000, 2014).
These are not original questions. They have been raised in the past in different academic and policy circles.

54

include indirectly the exchange rate and the housing sector. The former through the affect thatcurrency changes have on prices of tradables (and other goods, through second-round effects),
and the latter through imputed rent of owner occupied housing, and via the effect of housing on
economic activity. The question, then, is whether monetary policy rules should have additionalterms that incorporate these variables directly. John Taylor had this to say on why he excluded
the exchange rate in his original formulation of his monetary rule: 55“[T]he policy evaluation research that helped design the Taylor rule considered
the role of the exchange rate. Simulations of multicountry models led me tobelieve that if the central bank reacted too strongly to the exchange rate theninflation-output performance would deteriorate. It was for that reason that I
omitted the exchange rate in the Taylor rule for the United States.”

However, Taylor opined that this was not necessarily the case in every country; in particular,
there were instances where it was possible that a different prescription made sense for a small
open economy. He stated that:“…the same conclusion would not necessarily be reached for other countries,
especially small open economies. A country’s size, openness, capital mobility,and degree of exchange market development would matter.”
Most evaluations of policy rules with an additional exchange rate term have been in terms of thestandard deviation of inflation and output. However, it is possible that in a very open small
economy policymakers have additional objectives. If one of such goals is to avoid real exchange
rate misalignment – and in particular real exchange rate overvaluation of a Dutch disease type –,there may be an independent role for the exchange rate in the monetary rule. Two comments are
in order here: first, whether there is, indeed, such an independent role for the exchange rateshould only be determined after careful empirical evaluation of the specific Icelandic situation.
Second, it should be noted that including foreign central banks’ (Fed or ECB) interest rate into
the domestic policy rule, as has been suggested by Taylor and Edwards among others, would
incorporate some of the forces that may create short-term misalignment. This because, when theforeign central bank policy rate is included, there is a lower probability that interest rate
differentials will become “too large.” In this case it is unlikely that there will be (very) largechanges in the nominal exchange rate that would trigger (short and medium run) deviations of
the RER from its fundamental equilibrium.

55

Taylor (2000), p. 16.

55

It is important to emphasize that it is not possible to make a final and firm recommendation onthese issues before having additional information obtained through detail and thorough research.
Not all “housing sectors” are the same. Their importance varies from country to country for anumber of reasons, including the institutional characteristics of the mortgage market, thehistorical ownership ratio, the depth of the capital market, and the modality of financing use by
construction companies. In Iceland all of these variables are important and somewhat different
from advanced countries in continental Europe. In particular, and as noted, the boom in the
tourist sector, the long term indexed mortgages, and the funding of construction firms in the
short term capital market are fairly unique attributes. This suggests that a renewed effort should
be made to give this sector a more central role in monetary policy decisions, a point made inother countries by scholars such as John Taylor and Edward Leamer. It is too early to know
however, if housing sector variables (or index) should be added to the policy rule. This can only
be determined through additional research.
To summarize; There is a need to rethink – and possibly to reformulate -- the use of policy rulesin Iceland. This means, at least two things: updating the research on the subject, and making therule use more transparent. As a number of authors have pointed out, one reason for transparency
is that once the rule is known (in the understanding that it only provides guidance) policy actions
are more likely to affect expectations about the future and in this way will affect longer term
rates; this means an improved and stronger transmission mechanism. As noted above, some ofthe questions relevant for the case of Iceland -- are:•Should the exchange rates be incorporated as a separate term to the rule? Thisissue was addressed in Part One of this report, when the concern about “policy
spillovers” was addressed.

•

A second important question is whether in a small open economy with factor
mobility, is it still pertinent to consider the traditional output gap in the Taylor
rule? And if the answer is yes, should the coefficient be the same as in traditionalrules? If, on the contrary, the answer is “no,” which measure of output gap should
be used?

•Should asset values, including housing prices, be considered by the Taylor rule?
This question has to do with the “asset bubbles” and monetary policy question.
Since housing is one of the most important assets in many houselds portfolios,
this question is intimately related to whether the housing sector should beincorporated directly into the policy rule.

56•

In countries where the exchange rate is the main transmission mechanism, should
the interest rate in other central banks be part of the Taylor rule? 56

The unifying theme of all of these questions is what form, and which coefficients, should the
Taylor rule have in Iceland in order for monetary policy to be as effective as possible. The report
does not address this issue, and it would be useful that in future documents the CBI comments onthese questions.
E. Assessing the long term equilibrium value of the real exchange rate, the sustainable
current account balance, and the long-term sustainable NIIP
An important goal of macroeconomic policy in general, and of monetary policy in particular, ismaintaining macroeconomic stability. At a basic level this means keeping inflation close to its
target, and avoiding excessive volatility. Macroeconomic stability is endangered if some themacroeconomic variables get significantly out of line with respect to their long-run equilibrium
values. This is particularly the case with respect to the exchange rate.
Along these lines, it is important for the CBI to have a very clear idea of three key
macroeconomic variables: (1) the long-run equilibrium or “fair” value of the real effective
exchange rate (EREER), (2) the long-run sustainable current account balance, and (3) theequilibrium, and stable, sustainable net international investment position over GDP ratio for thecountry (NIIP). The September 2017 CBI refers to all three of these. However, from reading thereport it is not possible to know what type of models the Bank currently uses to assess theappropriateness of these three key variables at any moment in time. In the 2017/3 Monetary
Bulletin the CBI acknowledges that there is significant uncertainty surrounding the equilibrium
value of the RER:
“The equilibrium [real exchange] rate is expected to rise somewhat less thanpreviously assumed, in line with a poorer outlook for terms of trade and a forecastof a smaller external trade surplus, as is discussed below. Both the outlook and theestimate of the equilibrium real exchange rate are always subject to someuncertainty, however.”Similar issues arise with the NIIP, and with the sustainable current account balance. 57 Figure 6
contains data on Iceland’s current account balance relative to GDP, and on the NIIP to GDP ratio
for the period 2005-2016. 58 These data show clearly the remarkable changes experienced by theSee, for example, Edwards (2012, 2016)
The report refers to the current account several times – pages 12, 14, 16 and chart 3.4 –, but it does not provide
a discussion of the approach used by the CBI to determine whether the current account balance is withinsustainable brackets. The report, however, is almost silent with respect to the NIIP; see for example chart 3.5.
58
The paragraphs that follow are taken from the body of this report; see Part Two.
56
57

57

Icelandic economy. As may be seen, and as discussed in the Annex, in 2006 the current accountdeficit was close to 25% of GDP, possibly the largest deficit ever experienced by an advanced
country. As the chart shows, in 2008 the NIIP ratio exceeded 125% of GDP. Again, this ispossibly the largest negative NIIP ever experienced by an advanced nation; it even exceeds thevery large (negative) values in New Zealand during the early 2000. But the large imbalances
during the earlier years in the chart are not the most impressive aspect of it. What is really uniqueis the fact that over a period of 10 years, Iceland has moved from having a massive negative
NIIP to having a slightly positive one. As the chart shows since 2009 the country has posted verylarge current account surpluses.
The most important question that emerges from this graph, and one that the CBI needs to address
head on, is what is the long run, stable equilibrium NIIP in for Iceland. Is this a nation that in thenext decades ought to be a net creditor, such as Switzerland and Germany? Or is this a country
that will have a stable negative NIIP, such as the United States and the UK? This is not clear at
this point; in fact, the different CBI reports and publications are silent with respect to it. And yet,having a better notion will be fundamental in determining the appropriateness of the current realexchange rate, and thus the interaction between its value and monetary policy actions.

58
Figure 7: Current account balance and NIIP racial to GDP in Iceland, 2005 – 2017,(OECD calculations)

As noted, in the Annex to this report I review the different approaches used to evaluate whether
the RER is close to its long run equilibrium. I do that within the context of the Icelandic case,and I refer to some data from Iceland. My main conclusion from that discussion is that the CBIneeds to update its work on the subject, and it needs to establish a more comprehensive approachto evaluating real exchange rate equilibrium. Currently, the CBI uses its quarterly model QMM
to deal with this issue and to provide some guidance. It is unclear, however, how well this model
has operated with respect to this issue, and whether it has captured the structural changes throughwhich the economy has gone.
F. The effectiveness of capital controls and currency intervention

According to the International Monetary Fund, Iceland’s monetary stance could be characterized
as “inflation targeting plus.” 59 Within this description, the “plus” component refers to the factthat traditional inflation targeting is supplemented with two additional attributes: controls on
capital inflows in the form of “unremunerated reserve requirements,” and interventions in theforeign exchange market in order to reduce exchange rate volatility. Likewise, the CBI has
defined its “inflation targeting” as traditional inflation targeting supplemented with macro- andmicro-prudential regulations, including FX intervention and capital controls. 60
Since 2013, the CBI has made an effort to avoid (or reduce) real appreciation of the ISK. Thisfor three main reasons: A) ensure that the real exchange rate would not be too high when thecontrols would be abolished, B) prevent over-appreciation of the currency and Dutch disease
effect and C) to build up currency reserves before lifting the capital controls.
A key question, and one that the CBI report under consideration (September 2017) does nottackle in details, is what is the contribution of these two components to the effectiveness ofmonetary policy. As noted in Part One of this report, there is an abundant literature on both ofthese questions, and it would be extremely important that when evaluating the effectiveness of its
own policy, the CBI provides its view with regard to their specific contributions. To what extent
do they provide additional degrees of freedom? To what extent do they increase these the bank’s
ability to control macroeconomic aggregates, and thus to keep the rate of inflation close to its
target? Is there evidence that market participants are looking for ways to circumvent the controls
See also the different speeches and statements by the CBI's governor.
See https://www.cb.is/library/Skraarsafn--EN/Reports/Monetary%20policy%20in%20Iceland%20after%20capital%20controls.pdf
59
60

59

on inflows? Do market participants believe that the CBI has implicit “exchange rate bands” andoperate accordingly?
D_LOG_ISK
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
2010

2011

2012

2013

2014

2015

2016

2017

Figure 8: Daily percentage changes in USD/ISK exchange rate, 2010-2017

The CBI has stated clearly that its currency intervention policy is not geared towards protecting aparticular “level” of the exchange rate. 61 According to several policy statements the goal of thispolicy is to avoid excessive exchange rate volatility. An important question, and one that is notaddressed in the different CBI publications, is what is meant by “excessive,” and whether thisdefinition is static through time, or if it is altered depending on changing international financial
market conditions. In order to address this issue in Figure 8 I present data on the daily percent
the change of the ISK/USD rate since the year 2010. Perhaps the most interesting aspect of thisgraph is that the period of lower volatility corresponds to the second half of 2013 and the firsthalf of 2014. The graph also show a point made by the CBI’s Governor, in the sense that in early
2017, immediately after the controls on capital outflows were removed, there was a hike involatility. The data also indicates that volatility has subsided, and that towards the end of 2017 it
had declined significantly.
It is important to note that the low degree of transparency of currency market intervention
decisions adds noise to the market, and may result in destabilizing speculation. An important
policy recommendation is to move decisively towards a more translucent system.
An analysis of the time series of exchange rate changes allows us to understand how volatility
has evolved through time, but does not provide information on the comparative situation of
Iceland with respect to other nations. In order to provide some comparison of volatility in Iceland
it should be noted that there is a box in Monetary Bulleting 2017/4 where exchange rate volatility in Iceland andother nations is addressed.
61

60

and in other commodity exporting countries, in Figure 9 I present the percent the change of thebilateral exchange rates in Chile and New Zealand, both with respect to the US dollar.

D_LOG_CLP
.06

.04

.02

.00

-.02

-.04
2011

2012

2013

2014

2015

2016

2017

2015

2016

2017

D_LOG_NZD
.06

.04

.02

.00

-.02

-.04
2011

2012

2013

2014

Figure 9: Dailey change in the exchange rate for the bilateral US dollar to Chilean peso
and US dollar New Zealand dollar exchange rates, 2010 – 2017

The data in the table that follows provides a summary of the behavior of daily exchange ratechanges for these three commodity exporting countries for the period 2013-2017. As may beseen, the mean percentage change (in absolute terms) in the bilateral exchange rates in Icelandsits between that of Chile and New Zealand. The same is true of the standard deviation.
Interestingly, if one restricts the sample to the year 2017, the extent of volatility in Iceland
exceeds that of the other two nations.

61

Mean
MedianMaximum
Minimum
Std. Dev.
Skewness
Kurtosis

D_LOG_CLP0.000116-2.93E-05
0.031042-0.023041
0.005690
0.111958
4.110633

D_LOG_ISK-0.000212-0.000265
0.037888-0.037228
0.006366
0.134406
7.414931

D_LOG_NZD
0.000185
0.000239
0.039957-0.034835
0.007268
0.149373
5.070571

Jarque-Bera
Probability

57.282560.000000

873.0379
0.000000

195.3019
0.000000

Sum
Sum Sq. Dev.

0.124336
0.034637-0.227323
0.043358

0.197839
0.056525

Observations

1071

1071

1071

These graphs and table indicate, one more, that there is need for further analysis on behalf of the
CBI. Additional information is needed with respect to both the effectiveness of the capital
controls and the currency intervention policy. In that regard, the points made in the overall
discussion presented in Part One of this report are relevant. 62
All of these are important questions which should be addressed by the CBI, in order to provide afirmer terrain on which to discuss the important issue of monetary policy effectiveness.
G. Summary
After reading different CBI report, analyzing the data in detail, and interviewing a number ofindividuals from many sectors, my conclusion is that monetary policy in Iceland has been run inan effective way since approximately the mid-of 2012. Indeed, an important conclusion is that

An attempt to estimate Markov-switching regressions with equation dependent variances, failed to identify
clearly two volatility regimes for Iceland during this period. This is a preliminary and tentative result, which
deserves additional analysis. It is interesting to note that when the Markov regressions are estimated with acommon variance, it is possible to identify two regimes. However, providing the details of this type of technicalanalysis is beyond the scope of the current report.
62

62

since that time (2012-13) monetary policy has contributed in a significant way the recovery of
the Icelandic economy.
At the same time, it is important to acknowledge that the good economic performance of theeconomy – including the low rate of inflation – is partially a consequence of the benign
international financial conditions during these years. A key point of my evaluation is that in spiteof significant and clear progress with respect to monetary policy, there are still a number of loose
ends and areas where additional knowledge is required in order to increase even further theeffectiveness of monetary policy. Part Three of this report, which follows, provides moredetailed conclusions, and a score of specific recommendations. As noted, in the Annex I include
a detailed discussion on alternative techniques for identifying real exchange rate misalignment.
This is an important issue in Iceland, and one that the CBI should take seriously into account.
The main points made in this Part of the report may be summarized around five themes, all ofthem related to the need to improve the understanding of the functioning of the economy, and to
consider and evaluate introducing some adjustments to the monetary policy framework:a) Currency intervention: There is a sense in the market and among observers and analysts
that the current policy is not particularly transparent. An effort should be made to make it
clearer, possibly following the lead of the Reserve Bank of New Zealand. In addition, it
would be beneficial if decisions on market intervention are discussed in depth by the
MPC.
b) Capital controls: Controlling capital movements played a very important role in Iceland
recovery. However, as the country moves towards a “new normal,” the remaining
controls on inflows should be lifted gradually. The first step would be to set the rates of
the reserve requirements at zero. This may be done in steps. Initially the measure could
affect longer term bonds, followed by bonds with a high degree of liquidity (the yields onthese bonds are less likely to be affected by sudden changes in inflows).
c) Monetary rule: During the last few years the CBI has used a monetary rule (Taylor rule)as guidance. However, it is not clear what the form of that rule is at the current time(value of coefficients and/or terms), nor if it incorporates the structural break in economic
relations in Iceland. It is important for the CBI to consider modifying the rule. Morespecifically, two issues should be addressed: Should the policy rule include as anadditional term housing sector variables? Should the policy rule be modified, as toincorporate the policy rate in major central banks, such as the Federal Reserve and/or the
ECB? It is important to note is that other central banks are also grappling with theseissues.

63d) Transmission mechanism: As was pointed out in Parts One and Two of this report, there
is increasing evidence that in a globalized setting the nominal exchange rate becomes themain transmission mechanism for monetary policy. This seems, indeed, to be the case in
Iceland. Although this is not the same as “exchange rate targeting,” it does mean that theexchange rate becomes a central component and concern of monetary policy. Thus, thereis need for the CBI to update its models, in order to understand better the way in whichchanges in the policy rate affect the currency, and how, in turn, these changes impact on
prices. This last point has to do, of course, with the “pass–through” coefficient. A related
topic has to do with fully understanding the determinants of the long term equilibrium
real exchange rate, in order to evaluate at every point in time whether the observed RER
is consistent with fundamentals.
e) Housing sector: New research suggests that in a number of countries the housing sector is
one of the most important drivers of the business cycle and of inflationary expectations.
There is preliminary evidence that this is, indeed, the case in Iceland. For this reason, it isimportant that the CBI update its models on housing, and to consider, as discussed above,
whether a housing sector- related variable should be incorporated directly into themonetary policy rule.

64PART THREE:CONCLUSIONS AND RECOMMENDATIONS

65

Iceland has made remarkable progress during the last few years. Gross domestic product has
returned to trend and unemployment has all but disappeared. With tourism, the country has founda new source of foreign exchange.
The main conclusion of my analysis is that monetary policy has contributed in an important way
to Iceland’s recovery, and to the return of confidence. On March 17, 2017, Standard & Poor’s
upgraded Iceland’s sovereign debt to an A rating with a stable outlook. This was a very positive
showing, in particular if one considers that as recently as July 2015 the same rating agency had
given the country a BBB minus rating. 63 A review of monetary policy actions since 2012-2013
does not show any mistakes, or steps in the wrong direction. Of course, one could quibble here
and there on the timing and intensity of particular measures – the pace at which the policy rate
was reduced after June 2016, for example – but the overall conduct of policy by the CBI has
been professional and effective.
This does not mean, however, that there should be no changes/adjustment/reforms. As I havepointed out above, and as I argue in greater detail in what follows, there are a number of areas
where improvements should be made. Most of these have to do with increased knowledge by the
CBI of the way in which the economy works at the current time. As noted repeatedly in thisreport, Iceland has gone through a very major structural change during the last few years. Thismeans that with all likelihood the empirical relationships between different macroeconomic
variables have broken down, and changed drastically. In order for monetary effectiveness tocontinue to be high, or even to improve, there is need for major investment in research on theeconomy, there is a clear need to update the CBI’s models.
At the risk of being repetitious, it is important to go back to the historical background before
providing the main recommendations. In 1970, after the collapse of the Bretton Woods system,
Iceland adopted an adjustable peg with respect to the USD; this policy lasted until 1974. From1974 through 1983, the degree of flexibility of the exchange rate was somewhat increased andthe country followed what the CBI a “managed float” policy. This constituted a direct attempt attargeting the exchange rate. At first it was targeted relative to the USD and then relative tovarious currency baskets. Between 1984 and 1989 the exchange rate policy became more rigid,
and the exchange rate target more focused. However, since inflation didn’t subside, small
devaluations – ten overall – were engineered as a way of avoiding RER overvaluation; for allpractical purposes the country was following a variation of a “crawling peg” regime. Between
1990 and 1995 a renewed effort at exchange rate stability was made, and several exchange ratebands were used. Initially, the reference point was given by a 17 currencies basket, and the band
width was narrow: +/- minus 2.25% relative to the benchmark.The basket was redefined in 1992;
63

Standard & Poor's upgraded Iceland to BBB on July 17, 2015.

66

the USD was given an 18% weight, the Japanese yen 6%, and the ECU 76%. The króna wasdevalued in 1992 and 1993. In 1996 the width of the band was increased to +/- 6%, and a newbasket of 16 currencies was defined. From 1996 through 2000 the currency was allowed to movefreely within the band; in February 2000 the band was once again widened, this time to +/- 9%
relative to the basket target. This represented an important step towards a flexible/floatingexcgange rate regime. In 2001 the exchange rate target – or target zone – was eliminated and an
inflation target was adopted. This regime lasted until the 2008 crisis. This history, then, may besummarized as follows: the ISK has only floated freely from 2001-2008, a very volatile period. It
is generally recognized that during the first phase of inflation targeting – from 2001 through2008 – results were very poor. It is not an exaggeration to say that the policy stance during those
years, including extremely high interest rate differentials and lax supervision of the financial
sector, contributed significantly to the 2008 crisis. Since 2012 there has been a major change inpolicy. Inflation targeting has ben talken seriously, inflationary expectations have been properly
anchored and a much better communications policy has been followed. As noted, this improved
monetary policy, jointly with other measures, including the imposition of capital controls, havecontributed to the recovery of the economy.
There are four main recommendations, going forward. While one is generic, and applies to every
country, the other three are specific to Iceland. Each one of these main recommendations has anumber of specific – and sometimes quite detailed – suggestions.
1. It is important to realize that there is no “silver bullet” in terms of monetary
regime/policy. Although a country’s monetary regime is a fundamental component of its
economic/political institutions, it will not provide, by itself, all the solutions to every oneof the nation’s problems. Of course, the monetary regime and the concomitant monetary
policy can contribute significantly to achieving the goals of growth, low inflation, andsustained stability. But contributing to these goals is not the same as ensuring them. At
the end, socio-economic performance is the result of the interaction, in a very complex
way, of many policies and institutions; monetary policy is only one of them.
It is fundamental to note, however, that there is an important asymmetry: while themonetary regime cannot, on its own, ensure good socio-economic outcomes, monetary
policy mistakes (and irresponsibility) may result in crises and in significant instability.
That is, and to put it bluntly, an irresponsible monetary policy can, single-handedly, ruina country. History is replete of cases where flawed monetary policy has been at the heartof major crises. Argentina is, perhaps, the best example of this type of sad story. Thismeans that having a solid and efficient monetary policy is a required but not a necessary
condition for a country to achieve its goals.

67

Along similar lines, it is important to realize that there is a close connection between theexchange rate regime and the monetary policy regime. The central proposition that
captures this relation is the “trilemma”; it is not possible to simultaneously have a fixedexchange rate, and open capital account and an independent monetary policy. Countries
that have tried to violate this theorem – mostly by undertaking expansive monetary policy
under fixed exchange rates -- have paid for it dearly. In addition, there are trade-offs
regarding exchange rate regimes: while more flexible exchange rate arrangements willtend to act as absorbers for external shocks, more rigid ones (if credible and sustainable)
will help attain lower interest rates in most countries. This situation is known in theeconomics profession as the “flexibility-stability” trade-off.
2. After analyzing the data, scrutinizing the current policy procedures, investigating the pros
and cons of alternative options (flexibility vs credibility), after interviewing more thantwenty people, and considering the country’s history, culture and traditions, myconclusion is that at the current time the best monetary regime for Iceland is “flexible
inflation targeting.” 64This is, generally speaking, the monetary regime that the country has at the current time.
In that regard, my advice is not earth-shaking, and may be seen as espousing continuity
and defending the status quo. This, however, is not the case. There are a number of areas
where the current framework for monetary policy could, and should, be improved. Also,
here are a number of areas where he CBI should consider adjustments. In that regard, myrecommendation is that Iceland moves to what we may call, for lack of better
terminology, an “improved inflation targeting” monetary policy regime.
As was pointed out earlier, most modern discussions on the optimal monetary andexchange rate regimes are couched within the “credibility versus flexibility” approach.
As noted, countries that lack credibility and that mostly face domestic monetary shocks,
will benefit from a (hard) peg exchange rate regime, such as a currency board. This will
help them gain credibility and anchor inflationary expectations.
For a long time, a number of authors recognized the fact that Iceland had an importantcredibility deficit. This problem has historically been reflected in a succession of crises.
As a consequence, the nation’s rate of inflation exceeded, quite significantly, that of otheradvanced nations. Moreover, repeated attempts at using pegged exchange rates to gain
credibility failed. These failures were mostly the result of the fact that the exchange rate
arrangement was characterized by “soft” pegs, which were seen as having permissive“escape clauses.” It was, precisely, the fact that these soft pegs did not work what64

As noted above, the report only considered options with a “currency of its own.”

68

prompted a number of analysts, members of parliament and policy makers to suggest that
it was time for the country to consider moving to a more rigid type of institutionalarrangement, along the lines of a currency board or joining a pre-existing monetary
union, such as the Euro Zone. The problem with this type of regime, however, is that itleaves the country without a shock absorber to accommodate external shocks. As noted
above, there is ample evidence that flexible exchange rate regimes do provide that shock
absorber feature; this is particularly important in countries such as Iceland, with a highly
concentrated export sector and volatile terms of trade (see the discussion in the Annex).
At the end of the road, then, the selection of the optimal monetary regime will depend on
the combination of two factors: How important is the country’s “credibility deficit,” andwhat is the nature of the external shocks. The larger is the former, the more beneficial it
will be to have a rigid exchange rate regime. If, on the other hand, terms of trade shocks
are particularly severe, there would be a preference for a more flexible arrangement. As
pointed out in Part One, however, under flexible exchange rate regimes there is thedanger that the monetary authority follows an excessively lax policy that results in rapid
inflation. In that regard, flexible exchange rates – wich take advantage of the shock
absorber feature of variable currency values – will work better when the monetary
authority has a credible commitment towards low inflation.
It is undeniable that during the last few years – since approximately 2012 – the degree ofcredibility of the CBI has increased significantly. As the IMF and other external
institutions have pointed out, inflationary expectations are now quite firmly anchored,
and the inflationary target has been achieved, something that did not happen in the past.
This means that the attractiveness of hard peg regimes has declined during the last few
years. At the same time, it continues to be true that Iceland’s terms of trade are highly
volatile. In Figure 12 I present the difference of (the logarithm) of terms of trade for fivecommodity exporting countries – Iceland, Australia, Canada, Chile, and New Zealand, as
well as for the OECD. Summary statistics for these data are summarized here:
These data show that terms of trade volatility in Iceland is three times higher than the
average for the OECD countries. Although it is not the highest among the commodity
exporting countries in the sample, it is higher than that of Canada and not much higher
than that of New Zealand. Interestingly, all of these nations have flexible exchange rates
and an inflation targeting monetary regime. That is, they have all opted for having asystem that provides them with the shock absorber feature discussed above. 65

65These data are from the OECD. See https://data.oecd.org/trade/terms-of-trade.htm#indicator-chart.

69

Mean
MedianMaximum
Minimum
Std. Dev.
Skewness
Kurtosis

DLOG_ISL-0.002827-0.006194
0.065034-0.080827
0.033614-0.039464
2.710778

DLOG_AUS
0.012503
0.009414
0.187555-0.111198
0.074031
0.457898
2.972369

DLOG_CAN
7.62E-05-0.007105
0.053570-0.095877
0.033504-0.568926
3.436920

DLOG_CHL
0.022577
0.005283
0.219570-0.196889
0.091047
0.065555
3.131650

DLOG_NZL
0.011362
0.000848
0.109871-0.069270
0.040165
0.511552
2.908546

DLOG_OECD
0.000304
0.001318
0.027855-0.026611
0.013288-0.125208
2.977054

Jarque-Bera
Probability

0.134819
0.934813

1.259169
0.532813

2.228406
0.328177

0.043152
0.978655

1.582661
0.453241

0.055331
0.972714

Sum
Sum Sq. Dev.

-0.101786
0.039547

0.4501190.191822

0.002744
0.039287

0.677322
0.240396

0.409023
0.056464

0.006392
0.003531

Observations

36

36

36

30

36

21

Moreover, there are other characteristics of Iceland’s external sector and exports thatindicate that a flexible exchange rate that allows for the accommodation of shocks isdesirable. Iceland’s exports are highly concentrated. Indeed, according to an OECDindex, Iceland exports are significantly less diversified than those of Australia, Canada,
Chile, Finland, and New Zealand. The values of the concentration indexes for thesenations are as follows (higher index means less diversified): Iceland 3.91; Australia, 2.99;
Canada, 2.07; Chile, 3.69; Finland, 1.94; and New Zealand, 2.28. Furthermore, Iceland’s
exports have relatively low value added content; 65.3%. The equivalent figure for Chileis 81%, and for New Zealand 84.2%. 66
In addition to these “credibility versus flexibility” arguments, it continues to be the case,as Paul Krugman argued 25 years ago, that Iceland does not satisfy the main
requirements for an “optimal currency area.” This has to do with the degree of factor
mobility, and the lack of a common fiscal and monetary policy frameworks with theEuropean Union and Euro Zone.
The above discussion, and the arguments developed in the preceding parts of this reportsuggest that at the current time the most convenient monetary regime for Iceland is one
characterized by exchange rate flexibility and inflation targeting. As noted, however,there is room for improvement relative to current practices. Specific suggestions forpolicy reforms/adjustments are presented in the numerals 3 and 4, below.
66

https://data.oecd.org/trade/domestic-value-added-in-gross-exports.htm#indicator-chart

70

DLOG_AUS

DLOG_ISL
.20

.08

.16
.04

.12
.08

.00

.04
-.04

.00
-.04

-.08

-.08
-.12
1980

1985

1990

1995

2000

2005

2010

2015

-.12
1980

1985

1990

DLOG_CAN

1995

2000

2005

2010

2015

2005

2010

2015

2005

2010

2015

DLOG_CHL

.08

.3
.2

.04

.1
.00
.0
-.04
-.1
-.08

-.12
1980

-.2

1985

1990

1995

2000

2005

2010

2015

-.3
1980

1985

1990

DLOG_NZL

1995

2000

DLOG_OECD

.12

.03
.02

.08

.01
.04
.00
.00
-.01
-.04

-.08
1980

-.02

1985

1990

1995

2000

2005

2010

2015

-.03
1980

1985

1990

1995

2000

Figure 12: Change in log of terms of trade in five commodity exporting countries and OECD71

3. The most important suggested reforms/changes/alterations to the current policy
framework are the following. (For details see the body of the report, and the discussion in
the Annex):o Controls on capital inflows: The remaining controls on capital inflows should be
lifted gradually. As pointed out in Part One of this report, the international
evidence regarding “unremunerated reserve requirements” (URR) suggest thatthese don’t work effectively in the medium to longer run, as investors who wantto take advantage of the “carry trade” find ways of circumventing the controls. In
addition, URR introduce sizable distortions, since they work as an implicit tax on
capital.
My recommendation is that the reduction of the rate of the URR is reduced
gradually, pari pasu with policy rate adjustments downward.
It is also recommended that, at least for some period of time, the rate of thereserve requirements is set at zero, which is different from totally eliminating thepolicy. By following the suggested path, the URR would still be available in thepolicymaker’s tools kit, in case of need. The reduction in the URR may be done insteps. Initially the measure could affect longer term bonds, followed by bonds
with a high degree of liquidity. The yields on long term liquid bonds are lesslikely to be affected by sudden changes in inflows. This means that some heavily
traded corporate bonds are good candidates for having their URR reduced to zeroat an earlier stage.
Notice that by making this recommendation I am not minimizing the potential
problem generated by massive (and unstable) capital inflows that may be used tofinance local investment and/or unsustainable increases in consumption. Indeed,as many authors have documented, currency crises are usually preceded bysignificant credit booms, which many times are funded by speculative flows
coming from abroad, and which are seeking yield. This problem, however, is best
dealt with at the “financial stability” level, through the use of macro and micro
prudential regulations. These regulations should be aimed at making sure that
there are no currency mismatches in banks’ balance sheets. In the last few years
the CBI has made significant progress in implementing an effective system ofprudential regulations; this is an area where improvement has been important; thisissue is being analyzed in the context of the current policy review by Professor
Kristin Forbes of MIT.

72

o Reserve accumulation policy: In the last two years the Central Bank of Iceland
has followed a reserves’ accumulation policy that has resulted in a sizable stockof foreign reserves. At the current time this stock is estimated to be somewhat
above 1.5 times the amount recommended by the IMF (RAM).
It is suggested that going forward the CBI continues to have a reserves
accumulation policy that will maintain the stock of foreign assets at the central
bank significantly above the standard recommended level -- this is a prudent“self-insurance” policy for a very small and very open economy that faces volatileterms of trade. In that regards, between 1.5 and 1.8 times RAM seems to be a
prudent stock. However, it is suggested that the process through which the central
bank accumulates these reserves is made clear and is perfectly transparent tomarket participants.
o Intervention in the currency market: Besides the policy of reserves accumulation
mentioned in the previous bullet point, exchange rate market intervention by thecentral bank should be minimal, and follow a very transparent framework.
Currently, the CBI tries to smooth (large) changes in the ISK. The purpose of thispolicy, as stated by the CBI, is not to defend a particular level of the currency; itssole objective is to reduce volatility. Decisions on when to intervene and withwhich amounts to do it are currently taken by the governor. However, at this timethe exact decision-making rule is not particularly clear or transparent. This is so inspite of (very) recent efforts by the CBI to clarify its policy stance in this area.
This adds noise and uncertainty to financial markets. On these issues, see thediscussion in Part One of this report. It is recommended that the CBI considers theexperience of other countries. In particular, the case of New Zealand, with its“traffic lights” system, seems to be relevant for this discussion.
The policy followed by New Zealand, including the warnings by the monetary
authorities, was explained in great detail in the text, and should be consideredseriously by the CBI. In addition, it would be beneficial if decisions on market
intervention are discussed in depth by the MPC. This is likely to add stability to
the market.
o Policy interest rate differentials: The traditional view in monetary policy in open
economies – as captured, for example, by the Mundell-Fleming model withimperfect asset substitution – was that countries with floating exchange rates
could have an independent monetary policy; they could escape the so-called“policy trilemma.” Recent research, however, has suggested that this is not73necessarily the case – see the discussion in Part One. With a fair degree of capital
mobility there is a connection between domestic policy rates and the policy ratesof the major global central banks – the Fed and/or the ECB – even under purely
floating exchange rates. This phenomenon has been called “policy contagion” or“policy spillovers.”
Although defining the “optimal” policy rate differential between the CBI and theglobal banks is well beyond the scope of this report, it is clear that December
2017 level – 300 basis points with respect to the FED and 425 bps with respect tothe ECB – is not an equilibrium one. It is important for the CBI toconsider/research this issue, and define an equilibrium range for policy
differentials that reflect risk premia. It is suggested that in revising and improving
its policy framework the CBI takes a clear stance regarding the role policy rates in
the major financial centers will play in determining its own policy. As noted
during the discussion in Part Two, it is not possible to make a firm
recommendation without the proper research to back it. However, preliminary
data analysis and considerations based on other small open economies indicatethat it may very well be appropriate for Iceland to formally consider the type ofmonetary rule that has been developed in the “spillover” literature on monetary
policy.
o Understanding the transmission mechanism(s): The effectiveness of monetary
policy depends on the degree of understanding that central banks have of theeconomy. This is particularly challenging in Iceland, since after the crisis there
have been significant structural and policy-induced changes.
The Central Bank of Iceland has a quality and active research department, which
has conducted serious and important research through the years, and has provided
detailed analyses of the monetary and financial sectors. This department should be
strengthened and supported strongly, as additional knowledge of the mostimportant relations between key variables will help improve the degree ofeffectiveness of policy. As the CBI argues in Special Publication No 11, there
was a structural change in macroeconomic conditions (including policy) in
Iceland in 2012 or so. As a consequence of this, some of the relations – at thequantitative level – that were valid in the years surrounding the crisis do not apply
today.

74

Along these lines, it is fundamental that the authorities improve theirunderstanding of the following mechanisms/phenomena (this is a list of“expanded knowledge for greater monetary policy effectiveness”):


The way in which changes in the policy rule affect the yield curve, forboth indexed and nominal securities. There is evidence, for different
countries, suggesting that in the last few years changes in policy interest
rates have failed to affect long rate in the same way as in the past. This isrelated to what Alan Greenspan called the “conundrum”. It is important toknow, exactly, the extent to which this has happened in Iceland. How
strong (weak) is the transmission of policy changes along the yield curve?
Are there differences with respect to indexed and non-indexed securities?
Naturally, this is a key question for assessing the effectiveness ofmonetary policy.



The way in which changes in the policy rule affect the exchange rate, bothbilateral and trade weighted. A number of authors – including CBIGovernor Már Gudmundsson – have argued that in small open economies
the main transmission mechanism of monetary policy is the exchange rate.
However, currently there are no quantitative empirical estimates of the
impact of policy changes affect the value of the ISK. However, it should
be noted that this is a difficult relationship to estimate with any degree ofconfidence/precision. It is not an exaggeration to say that the nominal
exchange rate has become one of the most important – if not the mostimportant – intermediate variable in monetary policy. Without deep
knowledge on the interactions between exchange rates, interest rates,
inflation, economic activity, the housing market, and investment, it is notpossible to run a truly effective monetary policy.



A clear and precise understanding of the “pass-through” mechanism is ofessence for an effective monetary policy design in a small open economy.
This is particularly relevant in the case of Iceland, where recently there
has been an important divergence between the different components of the
CPI – housing and imported goods, in particular. While housing has been
increasing at robust rates, the imported (or tradable) goods component has
declined, mostly as a result of the strengthening of the currency.

The way in which changes in policy rates affect the housing market, bothin terms of prices and quantities. This is important for a number of

75

reasons, including the fact that owner-occupied imputed rents are a key
component of Iceland’s CPI. But this is not the only reason. Recent
research indicates that in some countries – most notably in the U.S. – thehousing is one of the most important drivers of the business cycle.
Although the sector itself is not a very large component of GDP, changes
in investment in housing predict most cycle turning points. The CBI – andother central banks, for that matter – should have a clear view of the way
in which changes in the housing market affect the cycle. This analysis, ofcourse, should be accompanied by research establishing the way in whichchanges in monetary policy affect this key sector. Given the recent surge
in the tourism sector, the housing market has acquired heightened
importance in Iceland. The CBI should pay particular attention at its
developments when formulating monetary policy. A possibility discussed
above is to incorporate a variable related to housing as an additional termin the policy rule. Whether this is an improvement over more traditional
approaches can only be determined after significant research.
An important question is the form – including the coefficient values – ofthe “Taylor rule” used to guide policy. In many countries this rule isconsidered in a rather mechanical way, maintaining the original
coefficients and the form suggested by John Taylor in the early 1990s.
However, there is no reason for the “best” rule in a small open economy to
be the same as in the United States; and of course, there is no reason forthe optimal rule in Iceland well enter the 21st century is the same as in the
United States in 1993. In particular, and as noted a number of times in thisreport, there are issues related to whether additional terms should beincorporated in such a rule, and/or whether the coefficients should
continue to be the traditional 1.5 for the inflation gap and 0.5 for the
output gap. Further analyses along these lines would be more thanwelcome and would help the CBI improve its monetary policy.

4. As noted above, the effectiveness and efficiency of monetary policy depend on otherinstitutions and policies. This means that for the “improved inflation targeting” regime
proposed in the previous bullets to work properly, and for it truly contribute to growthand stability, it is necessary to consider reforms in a number of other policies. In
particular, in this report the following areas have been identified:

76

o Labor markets flexibility: Iceland has a highly centralized wage negotiation
system, where unions play a central role. One of the main characteristics of thissystem is that each union tries to match the salary increase of other unions. This
process results in wage rate ratcheting, and in inflationary pressures, which in thepast have many times been validated by the monetary authorities. Historically,
this has resulted in high inflation, real exchange rate appreciation, and eventually
in major crises. Reforming this process, and moving to a more stable wage
negotiation system, that accomplishes similar real wage results, at a much lower
nominal wage levels is essential.
This is not a surprising suggestion: everyone in Iceland, and in the multilateral
institutions, is aware of the importance of this modernization of the negotiation
system. However, for political reasons, the country has been unable to do it. It
should be emphasized with extreme forcefulness that going through this reform isabsolutely of essence for Iceland to maintain the very hard fought stability that it
has obtained during the last few years. Without a modern, reasonable, and morestable wage negotiation system – a system similar to the one in place in the other
Scandinavian countries –, it will be very difficult for monetary policy to beeffective, and for the country to maintain macroeconomic stability.
o Increasing pension funds overseas investments: An important and (very) positive
characteristic of the Icelandic economy is that it has made a significant effort tomove towards a fully funded pension system. As a result of this effort pension
funds have accumulated assets in excess of 150% of GDP. This has put significant
pressure on the local financial market, which for a number of reasons has been
unable to provide enough instruments and securities to invest in. After the crisis,
and as a result of the capital controls, the percentage of pension fund assets
invested internationally declined significantly, from close to 40% to barely over
20% of the portfolio. It is important to encourage pension funds to increase theirinternational investments. This is beneficial for a number of reasons, including
portfolio diversification; it is also positive to have less pressure from these huge
pension funds, which sometimes act as monopsonies, in the local financial
markets.
o Organic budget law: As Robert Mundell argued 50 years ago, macroeconomic
outcomes depend on the policy mix: the combination between monetary, fiscal,
exchange rate, and wage rate policies. In that regard, it is fundamentally importantfor fiscal policy to support the monetary regime. The approval of Iceland’sorganic budget law, and the efforts to design budgets for a five-year horizon

77

represents an important step forward, and one that should be maintained, andimproved on in the future. In that regard, issues related to optimal debt
management are of paramount importance.

78

ANNEX:
MODELS FOR ASSESSING EXCHANGE RATE EQUILIBRIUM: A BRIEF
REVIEW AND SOME REFLECTIONS REGARDING ICELAND

79

Introduction
One of the main points of this report is that for a small open economy to run an effective
monetary policy it is essential for the central bank to have a clear idea of whether the realexchange rate is close to its equilibrium value. In this Annex I discuss different approaches usedin the literature to assess whether the real exchange rate departs (significantly andsystematically) from equilibrium. Throughout the analysis I make references to the case of
Iceland. It should be clarified at the outset, however, that this discussion is not an attempt toestimate the equilibrium RER in Iceland. Doing that is well beyond the scope of this report. 67
It is possible to classify the different methods used to evaluate the appropriateness of the (real)exchange rate into four groups: (1) models based on the purchasing power parity approach; (2)models based on the country’s external sustainability; (3) regression-based models based on realexchange rate “fundamentals”; and (4) an approach based on macro-econometric and DSGE
models. 68 In this section I review them briefly, and I argue that none of them provides a fully
satisfactory way of looking at the problem. I argue that in order to have a clear assessment of
RER values it is fundamental to combine these approaches in a careful way.
In the year 2007 IMF economist Robert Tchaidze published a Working Paper where he usedsome of these methods in an attempt to calculate the equilibrium value of the RER in Iceland.
This is a valuable report, done in a professional competent way. However, it was done before the2008 crisis and, consequently, does not take into account the major structural changes throughwhich the Icelandic economy has gone through. During the first half of the 2000’s the CBI also
undertook significant to work trying to determine the equilibrium value of the RER. Some of theresults obtained were reported in the first and third 2005 issues of the Monetary Bulletin. Again,
these efforts were undertaken before the crisis, and do not capture the new reality of the
Icelandic economy.
PPP and the equilibrium real exchange rate
As late as the 1930s there were very few economists who had thought thoroughly about the
subject. The two most important were Cassel (1918, 1922) and Keynes (1924). Another active
participant in this discussion was the Italian economist Bresciani-Turroni (1937), who analyzed
inflation and the equilibrium value of the German mark after the First World War, and whoemphasized the fact that the law of one prize did not hold on the aggregate if countries had
There is an extensive literature on trying to determine the equilibrium value of the real exchange rate. One of
the important point made in the report few examples going back to the 1980s include Edwards (1989), Williamson(1994), Wren-Lewis and Diver (1998), Montiel (1999), Edwards and Savastano (2001), Cline and Kim (2010).
68
For a detailed discussion of this topic see, for example, Edwards and Savastano (2001). In a comprehensive
review article, Isard (2016) points out that there are six methods for assessing equilibrium real exchange rates.
However, two of the methods that he describes, are variants, or sub methods, of the ones discussed here.
67

80

different production baskets. These three authors based their analyses on variations of thepurchasing power parity (PPP) doctrine. While Cassel and Keynes focused on price levels,
Bresciani-Turroni (1937, p. 139) emphasized rates of change, or the so-called “relative” version
of PPP.
The PPP approach is based on the notion that at some point in the past the real exchange rate wasin equilibrium, and that the value it had during that “base year” is representative of equilibrium
at the current moment. The application of the methodology implies undertaking at least two
steps: First, some kind of real exchange rate index is calculated for the base and subsequent
years. Second a comparison is made between the value of the index in the current moment andduring the “base or equilibrium” year. If at the present time (or at the time we are evaluating) thereal exchange rate index departs significantly from its value during the “base year,” it is said thatthe currency is misaligned; in these analyses “significantly” is not clearly defined a priori.
Possibly one of the most lucid application of this methodology was undertaken by Lloyd Metzler(1947), who estimated whether the currency value that the members of the International
Monetary Fund had declared as initial equilibrium, in December 1946, were in line witheconomically defined equilibrium. In this analysis Metzler used the average real exchange rate
between October 1936 and June 1937 as the “base year” for every country in his sample. Metzler
justified the use of this benchmark year as follows (p. 117):“This period was selected because it was relatively close to the war years but at
the same time reasonably free of war influences. If an earlier period had been
used, difficulties would have arisen from the wave of currency devaluations
which occurred in the early thirties and mid-thirties. If later period had been used,on the other hand, complication would have been introduced both by theAmerican depression of 1937–38 and by the effects which the eminence of war
had upon foreign exchange markets.”
In explaining why using PPP was appropriate and reasonable, Metzler said (p. 129): “The virtueof the parity rate is that it preserves the earlier real exchange ratio between the goods andservices of one country in the goods and services of another.”
Of course, Metzler understood that there were a number of limitations associated with thisapproach. A particularly serious problem was that individual prices moved in different ways
within each country and that these relative price movements were not capture appropriately by
price composites or indexes. In his words (p. 132):“When some prices or costs rise more rapidly than others within the same
country, no simple comparison between price movements in different countries

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can be made. The best that can be done is to use an average or index number of
price changes, and if the discrepancies in price movement between different
commodities in the same countries are large such an index number at best is only
a rough indication of the changes in the value of the monetary unit. Moreover,since several types of price index numbers are usually available, the calculation ofparity rate is not a simple procedure, but involves a considerable element of
judgment as to what prices and costs are important for a country’s balance of
payments.”
This difficulty in deciding which price level to use has led a number of analysts to suggest that it
is most appropriate to focus on “unit labor costs” instead of price indices. 69 The attraction of thisalternative is that by emphasizing costs in different countries, it provides an intuitive
measurement of countries’s degree of international competitiveness. However, this methodology
is subject to many of the same limitations as more straightforward PPP based analyses, which are
discussed below.
As noted, the main goal of Metzler’s study was to undertake a comparison between the initial“equilibrium” parities actually announced by the International Monetary Fund, and the rates
calculated by him using different versions of purchasing power parity. Metzler concluded that a
number of nations had announced “overvalued” exchange rates to the IMF. This was not an
auspicious way of launching the institution, since its mandate was to provide financial assistanceto countries that run into financial difficulties because of having an inadequate exchange ratelevel.
The PPP method for assaying the appropriateness of the real exchange has been criticized bytrade theorists for a number of reasons. A central limitation is that a mechanical application of
the method may lead to very misleading conclusions. This is because there is no reason for the“base period” to capture the equilibrium conditions at the present time or at the time of interest.
It is possible that the terms of trade, the degree of openness, and other variables – including
geopolitical ones – have changed through time, rendering the old equilibrium an irrelevant
historical relic. In an important paper Rogoff (1996) showed that there are large and persistentdeviations of purchasing power parity, which are only corrected very slowly in time. Indeed, thisfinding is considered to be one of the exchange rate related puzzles by the literature.
Another serious limitation of simple PPP calculations is that they don’t take into account the factthat productivity gains differ across countries. According to the Samuelson-Balassa effect theequilibrium real exchange rate will appreciate – the currency will strengthen in real terms – incountries that experience of faster productivity growth than their trading partners and69

Indeed, the CBI calculates several our ER indices, including one based on unit labor costs.

82

competitors. For details, including a survey of empirical studies, see for example Edwards andSavastano (2001). This fact has led some analysts such as Isard (2007) to argue that it isimportant to distinguish between the simple application of the PPP method, and a “productivity
differentials adjusted” PPP approach, where an effort is made to explicitly correct the simple
PPP calculations by productivity differentials.
In spite of its problems, this methodology continues to be used around the world by central
banks, investment banks, large conglomerates, consultants, journalists, and even someacademics. Isard (2007) reports that the simple application of the PPP methodology suggested
that in 2006, the USD was roughly in line with its long-term equilibrium. At the same time, the“productivity adjusted” PPP approach indicated that that same year the dollar was 11.5%
overvalued. Interestingly, Isard (2007) shows that when alternative methods are used, including
the external balance approach discussed below, extremely different results are found for the USD
in 2006: according to some of these methods the dollar was overvalued by as much as 25%,
while other methodologies suggested equilibrium.
The CBI publishes several RER indexes, using alternative prices/wage indexes. In the
publication Economic Indicators it publishes an index based on a relative unit labor costs andrelative consumer prices; it appears as Chart III-25. Although there is no reference to a base year,
or to a situation of equilibrium in the past, that chart presents the average value for both indicesduring the last 25 years. Some readers of the CBI report may interpret that as providing somekind of benchmark with respect to which the appropriateness of the current real exchange rate as
to be measured. According to these data, in the 2nd quarter of 2017 the RER index calculatedusing consumer prices was 26.7% stronger than the 25 year average; the index computer using
unit labor costs was, in turn, 41.2% higher (that is, more unappreciated) than the long-term
average.
In the most recent Monetary Bulletin, the CBI discusses the fact that the real exchange rate has
strengthened, and attributes, at least part of this movement, to changes in RER fundamental, andin particular to improved terms of trade. According to the Bulletin:“The equilibrium real exchange rate is likely to have risen in the recent term,owing primarily to improved terms of trade and rapid export growth, which
supported the current account surplus and improved Iceland’s external position(see, for example, Box 3 in Monetary Bulletin 2016/2). The revised estimateof the equilibrium real exchange rate suggests that the real exchange rate is close
to equilibrium or perhaps slightly below it. But this assumption is also subject toconsiderable uncertainty. Furthermore, the equilibrium real exchange rate could

83

fall again if the economy is hit by external shocks such as those described in thealternative scenario above, with a weaker outlook for exports.”
This quote also includes information about the interpretation of the data by the CBI at the current
time – end of 2017, beginning of 2018. In particular, it is interesting that, as noted in the body ofthis report, the wording is rather guarded, when it says “revised estimate of the equilibrium realexchange rate suggests that the RER is close to equilibrium…”
Figure A-1 present the evolution of the BIS RER index for Iceland between January 1994 andJuly 2017. These data, which were shown in the body of this report, capture different phases inthe external sector history of Iceland. In particular, the stability of the real exchange rate during
the early pegged exchange rate regime appears clearly; it’s strengthening due to higher inflation;
the 2000 – 2001 depreciation; the subsequent strengthening followed by the very large
depreciation as a result of the 2008 crisis. It also shows that the RER has strengthened
significantly until mid-2017, and retreated somewhat since then until the current time.

Iceland RBIS
Iceland RBIS
180
160
140
120
100
80
60
40

Figure A-1: Real exchange rate index for Iceland, BIS calculation

84

Current account balance, NIIP, and the equilibrium real exchange rate
A second popular methodology for assessing if a country’s RER is close to equilibrium, is toanalyze whether the current value of the RER is consistent with the country achieving “externalbalance.” In the simplest version of this approach the analyst asks what is the level of the RER
that is consistent with the country’s current account balance being equal to zero. Naturally, inorder to answer this question, it is necessary to have an opinion about variables that, jointly withthe exchange rate, determine the current account balance. These are the so-called “real exchange
rate fundamentals” and include the terms of trade, country risk premium, global interest rates,
degree of openness of the economy, demand for nontradables, and other.
A more advanced version of this method recognizes that a country may have, for prolonged
periods of time, current account balances that are different from zero. This approach, thus,
concentrates on the “sustainable current account balance.” See, for example, Milessi-Ferretti and
Razin (1998) for a discussion, including for some rules of thumb on levels beyond which acurrent account deficit becomes dangerous. Once the sustainable level of the current accountbalance is determined – say, a deficit of 2.5 % of GDP –, the analyst calculates the level of the
RER that is consistent with that particular current account balance.
The simplest way to derive the “sustainable” current account balance is to undertake an analysisof the net international investment position (NIIP) of the country in question. Roughly speaking,this methodology consists of the following steps: First, and through a global portfolio analysis,
the researcher determines the “equilibrium” net international demand for the country’s assets.
Once an equilibrium or stable ratio of the NIIP to GDP is established – this may be either apositive or negative number –, it is straightforward to estimate the sustainable current account to
GDP ratio. At this point, the analyst can extract, after assuming specific values of the“fundamentals,” the equilibrium real exchange rate which is consistent with this specificsustainable NIIP to GDP ratio, and associated current account balance. It is important to note that
this method requires -- as any sophisticated version of PPP does -- having a judgment about thelong-term equilibrium value of the “fundamentals.”This type of analysis has been used quite extensively in effort to determine whether the USD isout of line with long-run equilibrium. For example, in an extensive paper based on thismethodology, and published by the Brookings Papers on Economic Activity, Edwards (2005)
estimated that in the year 2004 the dollar was overvalued by around 11%. Using a similar
analysis, where the NIIP analysis is based on considerations related to savings and investment,
Isard (2007) estimated that in 2006 the USD was overvalued by more than 20%. Obstfeld andRogoff (2005) use of slightly different model that emphasized the role of tradable and85

nontradable goods, to analyze the extent of misalignment of the dollar in 2004, and concluded
that at the time t it was overvalued by approximately 25%.

Figure A-2: Current account balance and NIIP racial to GDP in Iceland, 2005 – 2017,(OECD calculations)

Applying this methodology to Iceland is particularly difficult, given the significant structuralchanges experienced by the economy. Figure A-2 – which is reproduced from the body of thereport -- contains data on Iceland’s current account balance relative to GDP, and on the NIIP to
GDP ratio for the period 2005-2016. 70 These data show clearly the remarkable changes
experienced by the Icelandic economy. As may be seen, and as noted in the body of this report,
in 2006 the current account deficit was almost 25% of GDP, possibly the largest deficits ever70

The paragraphs that follow are taken from the body of this report; see Part Two.

86experienced by an advanced country. As the chart shows in 2008 the NIIP ratio exceeded 125%
of GDP. Again, this is possibly the largest negative NIIP inner experience by an advanced
nation; it even exceeds the very large values in New Zealand during the early 2000. But the large
imbalances during the earlier years in the chart are not the most impressive aspect of it. What isreally unique and quite remarkable, is the fact that over a period of 10 years, Iceland has moved
from having a massive negative NIIP to having a slightly positive one. As the chart shows since2009 the country has posted very large current account surpluses.
The most important question that emerges from this graph, and one that the CBI needs to address
head on, is what is the long run, stable equilibrium NIIP in for Iceland. Is this a nation that in thenext decades ought to be a net creditor, such as Switzerland and Germany? Or is this a country
that will have a stable negative NIIP, such as New Zealand, Australia, the United States and the
UK? This is not clear at this point and having a better notion will be fundamental in determining
the appropriateness of the current real exchange rate, and thus the interaction between its value
and monetary policy actions.
Regression analyses of real exchange rate “fundamentals”
A number of authors – including economist at major investment banks – have used small
econometric models to assess whether a country’s real exchange rate is compatible with long-run
equilibrium. As a background for estimating such systems, many authors derive theoreticalmodels of open economies, which included the usual building blocks – representative consumer,
optimizing firms, and other –, and consider the existence of a number of external shocks,
including terms of trade and productivity shocks.
A simplified rendition of this methodology is as follows: from the theoretical model, and as
noted, a reduced form for the real exchange rate is derived and estimated. The covariates consistof the “fundamentals.” Depending on the degree of sophistication of the model, some monetary
variables may be allowed to have a short run effect on the real exchange rate (but not in long-run
equilibrium). Roughly speaking the RER is said to be “misaligned” if it’s actual value at any
given moment in time deviates “significantly” from the regression fitted value. Many of theauthors that have used this approach, including officials and researchers at investment banks
such as Goldman Sachs and J.P. Morgan, use single equation regression models. 71
A number of authors have argued that in order to perform this type of analysis correctly, it isnecessary to use “long-term equilibrium” values of the fundamentals. That is, the analyst needs
to make a judgment call with respect to, say, the long-run equilibrium value of the country’s
terms of trade. The simplest way of doing this is by decomposing the “fundamentals” into a
71

For an early application of this approach for a group of Latin American nations, see Edwards (1989).

87

permanent and a transitory component. The estimated “equilibrium” real exchange rate is
obtained by using the permanent components of the fundamentals in the estimated regression.
Examples of work along these lines include Baffes, Elbadawi and O’Connell (1997), Ades
(1996), Razin and Collins (1997), Halpern and Wyplosz (1997), and Iossifov and Loukoianova(2007).
In his 2007 paper on Iceland Tchaidze used this regression-based methodology; he included thefollowing fundamentals in the (logarithm of the) RER regression: net foreign assets as a fractionof import/export, a productivity differential that captures the Balassa-Samuelson effect, thelogarithm of the terms of trade, and the ratio of government expenditure over GDP. When thisequation was used by the CBI to assess the appropriateness of the RER in 2012, it was concluded
that the króna had to depreciate by 8% to 10% relative to its 2006 average in order to achieve
long term equilibrium.
In spite of their popularity, these type of models have a number of shortcomings. First, byconstruction, these models assume that the real exchange rate has been, on average, in
equilibrium during the period under study (this is the case if an intercept is included in the
regression). However, from an economic point of view there is no reason for this to be the casein every country. A second problem is that these models will tend to give very different results,
depending on the sample used, and on this specification considered. For example, Montiel (1997)
estimated that the Thai baht was significantly overvalued from 1981 to 1987, as well as from1992 to 1994. On the other hand, the model of Ades (1996) indicates that the Thai currency waspersistently undervalued between 1985 in 1993. Other examples include the Mexican peso:
according to Broner et al (1997) the Mexican currency was overvalued already in 1990; artists
suggest that overvaluation started in 1987; while Warner (1997) argues that the patient wasslightly undervalued until mid-1993.
Macro and DSGE models
In the last 20 years a number of authors have developed dynamic simulation models of open
economies and have used them to assess how the equilibrium exchange rate responds to different
shocks, both policy induced as well as exogenous. Some of these models have asked whether
central banks should respond to changes in global interest rates that stem from policy action inlarge nations. See, for example, Lubik and Schorfheide (2007).
Many of these models followed the framework developed by Obstfeld and Rogoff (2005). As has
become customary these models assumed utility maximizing consumers and profit maximizing
firms. They differ, however, on the assumptions with regard to the relationship between domestic
and international prices. While some models consider a version of the “law of one price,” others
assume that there is “pricing to market.” One of the challenges of these type of models is

88

incorporating a well specified financial and banking sector. See, for example, Edwards and Vegh
(1996) for an attempt along these lines.
From a practical perspective, many of these DSGE models generate results that are in line withthose obtained when using the external sustainability approach discussed above. For example,
Isard (2007) reports that when these type of models were used to assess the value of the dollar in
2006, they found that the USD was overvalued in the order of 20%, a number similar to thatobtained from his “external sustainability” model.
In addition to these DSGE models, a number of institutions, including the CBI and other central
banks, have used midsize macroeconomic models with estimated equations to analyze external
equilibrium conditions, and the appropriateness of the RER at given moment in time. The CBI’smodel has been used for a number of years, and has gone through a number of improvements andrefinements. This is the way the CBI describes it QMM model:“QMM is used in the Central Bank of Iceland to assist in analyzing the current
economic situation, making economic projections, assessing the effect of policies
and shocks, evaluating risks, handling uncertainty and with communication bothwithin and outside the bank… QMM is a one sector representation of the
Icelandic economy, containing 28 empirically estimated behavioral relations and
119 other equations, such as accounting identities and definitions.”
This model has helped CBI to conclude, as expressed in the latest 2017 Monetary Bulletin, thatin the months, there will be further strengthening of the RER. More specifically:“The equilibrium rate is expected to rise somewhat less than previously assumed,in line with a poorer outlook for terms of trade and a forecast of a smaller external
trade surplus, as is discussed below. Both the outlook and the estimate of theequilibrium real exchange rate are always subject to some uncertainty, however.”Summary: On the need of a holistic approachThis Annex shows two related things: First, there has been relatively little progress in theeconomics profession in the last 20 years, with respect to methods for assessing RER
equilibrium. The methodologies in vogue today are not very different from those used at the endof the 20th century. Second, these different methodologies, when used in their simplest versions,tend to generate ranges of estimates that, in some cases, may be very large. These very wide
intervals are not very useful for policy makers that need to assess the external situation when
making policy decisions regarding the monetary policy rate.

89

From Iceland’s perspective, this means that the CBI has to make further efforts in order to update
its own models, and try to find narrower intervals for estimating the equilibrium real exchange
rate. In particular, it is necessary to understand the whole issue of the long run equilibrium NIIP.
In principle, there is no reason why Iceland cannot be a long run creditor nation. However, given
the country’s history as a debtor one, this requires strong justification, and convincing.

90

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