Reassessing Iceland’s Monetary Regime*

Patrick Honohan
Trinity College Dublin
andAthanasios Orphanides
Massachusetts Institute of Technology

June 2018*

This report has been prepared for the Government of Iceland in the context of the review of
Iceland's monetary and exchange rate policy. It draws on information gathered primarily
during visits to Iceland in July and November 2017, including numerous discussions withcurrent and former officials of government and private institutions as well as academics andsocial partners. The report was completed in February 2018, this version reflects minor
editorial revisions. We are grateful to everyone who met with us or otherwise assisted us.

Executive Summary
Introduction
Iceland is an open economy which has been historically exposed to large shocks in thequantity and price of its major exports and, last decade, a major financial crisis. One result of
these shocks has been a long history of exchange rate surges; these exchange rate movements
have in turn been associated with inflation volatility.
The past fifteen years have been marked by a particularly wide fluctuation in key
macroeconomic indicators both real (economic activity) and nominal (exchange rates;
prices). The financial intermediation and property boom of the mid-2000s was succeeded bya systemic failure of the banking system, and a deep recession from 2008 with a sharp fall in
output and employment. The exchange rate depreciated sharply in both nominal and realterms, helping to restore competitiveness and underpinning a recovery in employment from2012. A vigorous expansion of tourism boosted the recovery, and helped turn a current
account deficit in the balance of payments into a surplus. Exchange controls on capital
movements, introduced soon after the initial collapse, insulated the economy from further
capital flow pressures and high interest rates eventually underpinned a substantial recovery in
the exchange rate. House prices recovered almost to their pre-bust levels. The net fiscal
costs of the banking collapse had been largely eliminated (thanks in part to various taxes and“solidarity contributions” paid by foreign investors), and the public finances had been placedon a sound footing by 2017. The authorities chose to remove controls on capital outflows inearly 2017.
The macroeconomic situation in Iceland at end-2017 looks more satisfactory than at any timein the past dozen years. Inflation, as measured by the consumer price index (CPI), is about inline with target. Unemployment has fallen below 3 per cent and the economy has been
showing a vigorous growth in output. The fiscal position is comfortable.
Yet Iceland has not shaken-off its vulnerability to major shocks. Accordingly
macroeconomic policy management needs to be maintained on a stability-oriented track.
With monetary policy now being operated once again without the protection of controls on
outward capital movements, it is timely to review the goals, operating procedures andgovernance arrangements around macroeconomic stabilization policy.
Inflation in Iceland
Looking back through the past three quarters of a century, Iceland’s inflation history is achequered one. Average inflation has been high and there have been as many as a dozen
episodes with double-digit inflation spikes. These spikes have most often been associatedwith recession triggered by supply shocks, whether in the form of export price or volume
contractions, global oil price shocks, or, in the case of 2008, a sudden stop of capital flows.
In effect, the nominal exchange rate depreciations, (although typically associated with a surge
in inflation) acted to depreciate the real exchange rate, and that resulted in a compression ofimports restoring a sufficient balance in international payments. These adjustments were1

achieved with a much lower impact on unemployment than similar adjustments in most othercountries, at least until the late 1980s, but at the cost of a seemingly ever-increasing
amplitude of the inflationary response. (The needed adjustments of the real exchange rateentailed much larger adjustments in the nominal exchange rate and inflation.)
General public dissatisfaction with the high and volatile inflation led to the implementation ofa tighter monetary and exchange rate policy that succeeded in stabilizing inflation from about
1991. Since then, large real exchange rate movements have been achieved with much lessmovement in inflation.
A formal inflation target regime was introduced in 2001. Although the macroeconomic
record since then has been far from smooth, an assessment of alternative choices of monetary
policy regime fails to suggest any better alternative type of regime. In particular, although
the severe shock of 2008 made the inflation target temporarily unachievable, the surge ininflation which followed was much less than had resulted from smaller shocks in the past andthe flexibility of the exchange rate facilitated a faster rebalancing of the economy than would
have otherwise been achieved. The experience did not undermine the consensus view in
Iceland that price stability should remain a key policy objective.
The goals of monetary policy
We share the widespread view in Iceland (as elsewhere) that the main objective of monetary
policy should be price stability. Central Banks have additional goals, especially in times ofcrisis, when it is vital to maintain financial stability if overall economic performance is to be
maintained.
That said, there could be different approaches to achieving price stability. One key issue iswhether stabilizing the exchange rate should be a subsidiary goal or intermediate target formonetary policy, and if so to what extent.
Before the removal of most of the outward exchange controls, the Central Bank was, in thepast few post-crisis years, intervening heavily to rebuild reserves. More recently, though, it
seems to have moved to a much less active stance, confining itself to moderating highfrequency volatility in the exchange rate.
It is true that the Icelandic economy is particularly prone to exchange rate volatility, and it
has been suggested that this warrants more attention being paid to dampening exchange rate
movements than has very recently become the case. We believe that this suggestion has
some merit, but would caution strongly against this line of argument being pushed too far.
For one thing, rather than always being sources of disturbance, exchange rate movements
have often performed a vital adjustment mechanism to help insulate the economy from othershocks. A regime which induced the monetary authorities to block such corrective exchange
rate movements would transfer the burden of adjustment to shocks onto wages and prices,which are less likely to respond quickly, resulting in unemployment and other imbalances.
Given the adoption of a common currency by 19 European countries, it is natural to consider
whether there might a case for some form of fixed exchange rate regime for Iceland. It might2

be argued that a perfect coordination of steady fiscal policy combined with rapid adjustabilityof nominal wages to absorb any shocks that hit the economy would make a fixed exchange
rate acceptable by ensuring that the economy was able to speedily adjust to any shocks thatmight arise without resulting in unemployment or other imbalances. However, neither fiscal
policy nor (despite the exceptionally high unionization rate of Iceland) wage setting can besafely relied upon to perform sufficiently smoothly to absorb all such shocks. Furthermore,
the growth in the scale and speed of international capital flows in recent years means that few
small advanced economies can be sure of the capacity to maintain a fixed exchange rateindefinitely in the face of determined speculative flows. Even the restrictions of a currencyboard arrangement are no guarantee in this regard. Current and, to some extent, prospective
members of the euro area enjoy mutual arrangements which make stability of their currencies
more secure. However, such arrangements could not be contemplated unless Iceland decided
to pursue membership in the European Union.
Although a fixed exchange rate regime is inadvisable, there is something to be said for taking
greater account of exchange rate movements in influencing the choice and tactical
deployment of monetary policy tools, including foreign exchange market intervention andmacroprudential measures affecting capital flows. The exchange rate strongly influences
inflation as well as aggregate demand; policy tools that can act directly on it are usefulcomplements to the main tool of monetary policy, namely the short-run interest rate. The
Central Bank already uses intervention to smooth very high frequency exchange rate
movements, and the capital inflow management measure that has been in effect since June
2016 can also be considered as an example of supplementary tools being used to stabilize
exchange rates. Still, such “leaning against the wind” could usefully be employed moreenergetically with a view to ensuring that movements in exchange rates do not deviate too far
from equilibrium trends.
The impact of indexed mortgages
Most residential mortgages in Iceland are currently CPI index-linked and carry a long-term
fixed interest rate. The responsiveness of the mortgage rate to changes in the monetary
policy rate, which is a short-term rate, is limited. This reduces the effectiveness with whichmonetary policy is transmitted to the economy, by comparison with other countries in which
the influence of monetary policy actions on the residential property market is often thestrongest transmission channel. That being so, the potential macroeconomic stabilization
function of such macroprudential instruments as restrictions on high loan-to-value mortgages(among others) deserves special attention. Given the sizable role of pension funds in themortgage market (both directly and through their acquisition of mortgage-backed bonds fromother lenders), such measures would need to extend to the pension funds as well as to thebanks if they are to be effective.
Indeed, while the operations of the pension funds are highly influential in setting the priceand influencing the availability of mortgage finance, the activities of this concentrated sector
do not seem to have been the subject of close attention from the point of view of efficiency
and macroeconomic stability. A relaxation of the capital inflow restrictions, when3

appropriate, could help increase competition in the market for long-term index-linked bonds.
Direct intervention by the Central Bank in this market for the purpose of enhancing theeffectiveness of monetary policy is not completely out of the question, but may not be easy to
implement effectively, given the comparative lack of international experience with thissomewhat idiosyncratic kind of market. Nevertheless, the activities of the pension funds
should receive increased analytical attention with a view to informing any appropriate use of
macroprudential measures.
Definition of inflation target
The Central Bank aims to achieve an annual inflation rate of about 2½ per cent, as measured
by the CPI. The 2½ per cent goal is broadly in line with global practice among advanced
economies and we do not find compelling reasons to modify it going forward. The adoptionof the CPI for the purpose of inflation targeting aligns with the use of the same index as thebasis for most residential mortgage contracts, and the CPI is also normally referenced inwage negotiations. However, the choice of index deserves further consideration, in particulargiven the importance of house price inflation in the index.
There is no general agreement among specialist statisticians worldwide on the best way ofmeasuring the appropriate contribution of housing to consumer price developments. For thisreason, the ECB uses an index which excludes housing for its measure of price stability. The
method adopted in Iceland is within one of the three main standard approaches, but it isoverly sensitive to short-term movements in house prices. The result is that periods ofunusually low or (as recently) unusually high house price movements have a strong influenceon the overall CPI.
Choosing to stabilize this measure of CPI could well have the effect of destabilizing the
average price of non-housing goods and services. Given the recent rapid house inflation in
the past few years, the stability of CPI inflation in Iceland has implied falling prices on
average of other goods and services. Differences in readings of inflation measured withalternative indexes produced by Statistics Iceland have been large and economicallymeaningful. During 2017, while average inflation measured by the CPI was +1.8 per cent,inflation measured by an alternative index excluding housing (CPIXH) was −2.2 per cent.
Had this alternative been targeted, more accommodative monetary policy might have beenchosen in recent times.
Although its widespread use in mortgages and in wage negotiations (even though formal
wage indexation is a thing of the past) means that any significant change in the index used forthe inflation target needs to be carefully prepared if legitimate expectations are not to beundermined, there is a case for moving from the current definition of CPI to one which is lesssensitive to short-term fluctuations in house prices, or even to CPIXH. As things stand, werecommend that CPIXH should also be tracked with a view to permitting a wider transitory
overshoot of the CPI target whenever housing prices are rising unusually rapidly (and viceversa). This thinking also reinforces the argument for using macroprudential tools more4

energetically to influence overheating in the housing market and contain the risk of recurrent
boom-bust cycles.
Governance issues
In implementing monetary policy, the Central Bank has been influenced by global bestpractice, adapted for the practicalities of a small institution in a small country. Governancearound monetary policy, with decisions taken by a monetary policy committee comprising
three internal members and two externals, seems generally satisfactory and removes overdependence on one decisionmaker.
The Central Bank employs a macro-econometric model of the economy to guide its
deliberations, but has wisely opted not to follow the forecasts of this model slavishly, instead
recognizing its value only as one of many inputs and striving to pursue robust policies,
accounting for the unavoidable uncertainties in macroeconomic analysis.
Communication around the Central Bank’s deliberations and publication of its researchfindings displays good transparency. It is less clear whether the general public have a goodawareness of the aims and tools of the Central Bank: of what it is doing and why it is doing it.
This may reflect the challenges associated with restoring stability in the aftermath of thecrisis, including the Central Bank’s role in the management of capital controls. Goingforward, the Central Bank’s strategy for interest rate policy and exchange rate policy should
be more straightforward to communicate.
Because of the strong influence of prudential policies on the functioning of the financial
sector, and on the effectiveness of macroeconomic stability policy in general, it is vital that
there be sufficient smooth and open communication between the Central Bank and theprudential financial regulator.
Indeed there are two formal committees designed to achieve such communication on
macroprudential policy. One of these, the Systemic Risk Committee, which is chaired by theGovernor, is more technical and can be considered as preparing material for the Financial
Stability Council on which the Governor and the CEO of the prudential regulator FME bothsit, and which is chaired by the Minister for Finance and Economic Affairs.
In such a small economy, there is much to be said for pooling the closely related expertise
required for the monetary policy and prudential regulation functions, and bringing them
together under the Central Bank, as has indeed been the trend in several other countries postcrisis. The case is strengthened by the potential importance of more active countercyclicaluse of macroprudential tools to augment the monetary policy toolkit. It might also be easierto achieve the enhancements proposed by other recent reviewers of Iceland’s prudential
regulation if this function was brought into an expanded Central Bank, for example with a
new Deputy Governor at the Central Bank charged with oversight of financial supervision.

5

Conclusion
Iceland has returned to a reasonable degree of macroeconomic stability. It is important toremain vigilant and for policymakers not to drop their guard against the re-emergence of
unsustainable or destabilising behaviour, public or private. The existing institutionalarrangements for securing macroeconomic stability, including monetary policy, seem
generally fit for purpose. They will however, be tested in the coming years with budgetarydecisions and wage negotiations (not least given that real wages are now on average well
above the previous historic peak). Improvements in the objectives, tools and governance ofmonetary policy should be incremental rather than drastic. They should be accompanied by astrengthening of the frameworks and ambitions for macroprudential policies, including thoseaddressed to the lending operations of the pension funds.

61. Introduction
Iceland’s monetary history has been unusually eventful. Following a long period of high andvolatile inflation, as well as sharp exchange rate movements, major economic reforms were
implemented in the 1980s and 1990s. Iceland joined the European Economic Area (EEA)
and adopted many elements of the institutional and regulatory framework of the European
Union (EU). In 2001, the country adopted inflation targeting, and formalized price stability
as the primary goal of the central bank. A financial boom during the mid-2000s was
succeeded by a systemic failure of the banking system and a deep recession, coinciding with
the Global Financial Crisis that plagued most advanced economies. Despite the inflationtargeting regime in place, and the imposition of exchange controls on capital movements,
inflation rose sharply and the real and nominal exchange rate depreciated sharply. Since
2010, the Icelandic economy has experienced a remarkable recovery, and macroeconomic
policy has been gradually normalized. With the removal of most controls on the outward
movement of funds, the return to price stability and a general expectation for continued low
inflation, and a strong rebound in the external value of the Icelandic króna, this is a good timefor Iceland to review the framework and objectives of monetary policy.
This report responds to a request by the Government of Iceland to carry out a review ofmonetary policy covering three main areas. Our terms of reference are as follows:First, evaluate the experience and the operation of the Central Bank´s inflation
targeting regime since 2001. This involves both assessing the respective processes
concerning data analysis and forecasting within the Central Bank and thecorresponding policy decisions, and subsequently evaluating the policy paths chosenconsidering economic outcomes.
Second, evaluate the operational challenges of conducting monetary policy in Icelandand the current use of policy instruments considering economic outcomes withsuggestions of improvements or alternatives. Furthermore, identify any potential
weakness in the current institutional framework of how monetary policy is conductedin Iceland both within the Central bank and in a broader setting, and suggest
improvements within the framework of inflation targeting.
Third, evaluate other options concerning monetary policy than the current inflation
targeting regime considering both structural characteristics of the Icelandic economy
and historical experience. This evaluation entails both consideration to alternative
targets of an independent monetary policy with a floating exchange rate as well fixing
the exchange rate with e.g. a Currency Board.
A number of distinctive features of the Icelandic economy and financial system need to betaken into account in addressing these questions. As one of the smallest of the world’s
advanced economies, and one which has depended substantially on a relatively narrow rangeof sources of foreign exchange, the Icelandic economy is especially vulnerable to external
shocks, often showing up in sizable exchange rate fluctuations. The long history of high andvariable inflation, and the remaining legacy of the exceptionally severe financial crisis of7

2008, mean that financial stability is inherently fragile in Iceland. The institutional structureof the financial system also has some rather unusual features, with a relatively large andconcentrated pension fund sector with total assets larger than that of the banks, and an
ownership structure of the banking system still evolving post-crisis. The heavy use of CPIindexed contracts in the financial system is a particularly important feature for the conduct ofmonetary policy.
Iceland has been operating an inflation targeting (IT) regime of monetary policy since 2001,
but with shifting emphases in practice and in governance.
At the time of writing, Iceland enjoys inflation within the target range, a rate ofunemployment that is by international standards very low, a rapid rate of economic growth
driven notably by an extraordinary expansion in tourism receipts, budgetary and current
account balance. Yet nominal interest rates are much higher than in most other advanced
economies at present, and the exchange rate appreciation, especially during 2016-7, hascaused concerns about the dangers of a loss of competitiveness. Surveys signal a decline inbusiness optimism during 2017.
Is there reason to revise the goals, operation or governance of monetary policy in Iceland?
That is the topic of our report. It is arranged as follows. Section 2 discusses the long-term
history of unusually high and volatile inflation, looking at the interaction between inflationand exchange rates, supply shocks and the nature of the monetary policy response. It notesthat policy shifted in an anti-inflation direction towards the end of the 1980s: the adoption of
IT in 2001 formalized this policy shift. Section 3 turns to the experience of IT, distinguishing
between the disappointing record of its first decade and the more successful outcome since2012. Section 4 assesses the current statutory powers and operational arrangements at theCentral Bank for delivering an effective monetary policy to achieve the inflation target. The
main alternative to IT that has been suggested as a potential anchor for monetary policy
would involve an exchange rate peg. Section 5 reviews various forms of exchange rate pegs
as to desirability for economic stability and growth and as to long-term feasibility. The
conclusion drawn is that, for Iceland (outside the euro area), an inflation-targeting regime islikely to outperform any pegged exchange rate regime in most relevant dimensions. In
Section 6 we look at three potential enhancements of the operating procedures of monetary
policy within the IT regime. First, a more active role in intervention or macroprudential
policies to reduce the amplitude of fluctuations in the exchange rate; second, the choice of
price index for IT, especially in relation to housing costs; third, a more active use of
macroprudential policy directed at the index-linked mortgage market to reduce the needed
amplitude of policy interest rate movements. Section 7 presents a list of recommendations
and section 8 concludes.
2. Monetary policy in the century since independenceHigh and volatile inflation before 1990s
For most of the century since becoming an independent state on 1 December 1918, Iceland
has experienced high and volatile inflation. Although it never succumbed to hyperinflation,8

its recurrent bouts of currency depreciation and inflation marked Iceland out by the 1970s as
one of most inflation-prone of the advanced economies (Figure 1).1 The post-war decades
were punctuated by repeated episodes of very large devaluations, with the ISK losing 50 per
cent or more of its value against the USD in 1949-50; 1960 and 1983, along with several
other smaller adjustments (Figure 2). With an inevitable pass-through of import costs into
domestic prices, these devaluations were associated with surges in inflation. Average annual
inflation was over 25 per cent for three decades before stabilization began around 1990.
Historical analyses identify a variety of triggers for the devaluation episodes (Andersen andGuðmundsson 1998). Sometimes inflation preceded exchange rate depreciation, sometimes it
followed. But the common feature in most of the episodes is the role of commodity exports,
especially fisheries. When supply or price of exports was strong, the exchange rate could bestable even as wages and overall prices rose; when export receipts weakened, the exchange
rate would have to be depreciated.
This experience reveals that, regardless of policy statements, price stability had a low priority
in Iceland’s macroeconomic policy during those decades. Any policy commitment toexchange rate stability was only for the short-term and was readily abandoned in the face ofadverse shocks; positive shocks did not usually lead to nominal exchange rate appreciation.
Policymakers generally put greater weight on accommodating adjustment to adverse external
shocks, maintaining the profitability of the export sector and defending high employment in
the short-run without much regard to any longer-term consequences of high and volatile
inflation.
Both in the 1940s and in the 1970s and 1980s, recurrent episodes can be identified when highdomestic inflation was tolerated for a time, with the nominal exchange rate pegged andnominal interest rates kept too low to rein in price increases. The resulting appreciation of
the real exchange rate would eventually prove unsustainable and lead to a crisis, forcing adevaluation and abrupt correction (Figure 2). The pernicious cycles of inflation anddevaluation continued until the 1980s when a rethinking of the macroeconomic policy
framework led to fundamental changes and eventually succeeded in stabilizing inflation.
Role of government in monetary policy
Until 2001, Iceland’s monetary affairs were mainly controlled by the Government. In thefirst few decades following independence, central bank functions were performed by thestate-owned Landsbanki Íslands (National Bank of Iceland), which was also Iceland’s maincommercial bank. The Central Bank of Iceland, Seðlabanki Íslands, was established by an
Act of Parliament in 1961. At the outset, the new entity was in effect created by separatingLandsbanki´s central banking department from the rest of the bank, forming an autonomous
Central Bank. The Central Bank was given a “dual” mandate that was conventional at the1
The data in this and other figures is drawn from official sources, i.e. Central Bank of Iceland, Statistics
Iceland, the IMF and the OECD, as available at end-2017 and, for the earlier years, Jónsson and Magnússon
(1997).

9time the Bank was established. Article 3(a) of the Central Bank of Iceland Act in effectbefore the adoption of inflation targeting, instructed the Bank:
to issue bank notes, to mint and issue coins, and to endeavour to maintain a supply ofmoney and credit appropriate for a stable price level and for full and efficient utilizationof the productive capacity of the economy. (Central Bank of Iceland, 1986, p. 1.)
However, the Central Bank lacked the independence necessary to pursue monetary policy andmonetary affairs continued to be controlled by the Government well into the 1990s. Even
though Article 1 of the Central Bank Act indicated that the Bank was an “independent
institution,” operational independence was only given to the Bank by Parliament in 2001,
with the introduction of the inflation targeting regime. Before then, the Central Bank was
obligated to implement “such policy as the Government ultimately lays down.” Specifically,
according to Article 4 of the Central Bank of Iceland Act in effect prior to the adoption of
inflation targeting:
The Central Bank shall in all its activities maintain close co-operation with theGovernment and present its views on policy in economic affairs and theimplementation thereof. In the event of significant disagreement with the Government
the Board of Governors of the Central Bank may state so publicly and explain its views.
It shall, nevertheless, consider it as one of its main objectives to endeavour toimplement such policy as the Government ultimately lays down. (Central Bank of
Iceland, 1986, p. 2.)
Interest rates were set by the Central Bank subject to Government approval, which resulted in“opportunistic political intervention” and monetary instability (Jónsson, 1999, p. 6). Rates oncommercial and housing loans were kept below clearing market levels (ex post real interest
rates tended to be negative), generating an excess demand for loans and the need forregulation of the supply through credit controls. The discount rate was kept below the
inflation rate for most of the high inflation period. It was not until the 1980s that the Central
Bank was allowed to create positive real policy interest rates to control credit growth (Figure3). Before then, attempts to control credit expansion were ineffective as the Central Bankwas unable to effectively control the degree of monetary accommodation and did not havefull control of its balance sheet. For example, by the late 1970s, an important factor
contributing to excessive accommodation was the automatic rediscounting of export produce
bills, which in effect provided credit to exporting sectors, fisheries in particular, at negative
real interest rates (OECD, 1979). In addition to using the Central Bank to provide subsidized
credit to industry, during the 1970s and 1980s the Government also relied on the Central
Bank to finance part of its deficits (OECD, 1991).
Despite this chequered record of inflation, the Government’s interventionist policies in the
post-World War era managed to maintain relatively high employment and growth. On
average, real GDP per person has been growing at a pace comparable to that of other Nordic
countries. In light of the economy’s exposure to real external shocks, however, policy could
not protect the economy from overall economic instability (Figure 4). The real exchange rate
10

(Figure 5) has fluctuated considerably, even in periods when the Central Bank attempted tocalibrate the depreciation of the currency to limit the divergence of the real exchange ratefrom estimates of its equilibrium level.
Introduction of indexation
The pervasiveness and volatility of inflation in Iceland had long been associated with wage
indexation. Gradually, indexation of financial contracts became more prevalent, starting in
the 1950s, but not fully developed until the 1980s. For example just 40 per cent of mortgage
loans outstanding in 1978 were partially indexed, but this had risen to 94 per cent by 1982;
fully indexed housing loans dominate today, complicating (as we will see) the monetary
policy transmission mechanism and monetary control.
Legislation enacted in 1979 put in place a comprehensive indexation system which provided
for certain financial contracts to be linked to a price index. Where approved, loans could beindexed to a special “credit terms index” (CTI) which was established in 1979 for that
purpose. At the starting point, the CTI combined the cost of living index, with a weight of
two thirds, and the building cost index, with a weight of one third. The precise calculation of
the CTI was subject to changes during the 1980s and 1990s and in 1995 it was replaced by
the consumer price index (Jónsson, 1999).
Despite the move to indexed financial contracts, the rate of inflation spiked to its highest
level in 1983, with year-on-year inflation readings exceeding 100 per cent for a few months.
Against this background, the Government embarked on a program of financial reform(including deregulation of interest rates) and structural change (including suspension of wage
indexation) which helped reduce inflation, though it remained in high double-digits until
1989.
Liberalization and monetary policy reform
Monetary reform proceeded in several steps. Starting in 1984, depository institutions werepermitted to set interest rates and by 1986 interest rates were virtually fully deregulated.
These changes helped contain the excessive nominal credit growth that prevailed at the peakyears of inflation and facilitated the disinflation process. In 1985, the Government abolishedthe rediscounting system that the Central Bank had used to provide subsidized credit toindustry.
The liberalization of the financial sector continued in the late 1980s and early 1990s,
reflecting, in large part, the formation of the European Economic Area and the requirements
for harmonization of legislation in Iceland with prevailing regulations in the European
Community and the European Union that succeeded it. Starting in 1990, capital controls
were gradually relaxed and subsequently eliminated. Banking and securities markets
legislation was changed in 1993 in line with EC directives. Following an agreement between
the Government and the Central Bank in 1992, the practice of using a Treasury overdraft
facility in the Central Bank to finance part of the Government deficit was discontinued. A
market for trading Government debt was developed and the Government began issuing
11Treasury bills in auctions. These changes gradually ended the Central Bank’s role as amarket-maker for Government securities.
In 1998, the Central Bank of Iceland implemented changes in its monetary instruments tobring them in line with the practices anticipated to be followed by the European Central Bank
following the introduction of the euro. The changes were meant to “harmonize as far as
possible the operating environment of the domestic credit institutions with that prevailing in
the European Economic Area” (Gunnarsson, 1999, p. 7). Together with the harmonization ofbank regulation to European Union law, which had already taken place, these changes were
designed to allow Icelandic banks to operate in a similar environment to that of banks
elsewhere in Europe. Starting in 1999, bank supervision was moved from the Central Bankof Iceland to the Financial Supervisory Authority (FME), in line with the prevailing fashionin other Nordic countries and in the UK and indeed in much of the European Union.
The reforms of the late 1980s and early 1990s allowed the Central Bank to implementmonetary policy more effectively and succeeded in stabilizing inflation since about 1992
(Figure 6). Lacking full operational independence, however, the Central Bank was not in aposition to tighten monetary policy promptly and sufficiently to maintain low inflation and an
inflationary bias remained in place. This became an issue by the end of the decade when the
failure to tighten policy sufficiently to contain the economic boom of the late 1990s led to
rapid credit growth, an overheated economy and a current account deficit that undermined thestability of the currency that was still used as a monetary anchor. Under these circumstances,and reflecting the evolution of central bank practice in other countries, the Government of
Iceland embarked on a review of the framework governing the operations of the Central Bankand monetary policy. The outcome of this review was the formal adoption of inflation
targeting (IT) as the main goal of monetary policy in March 2001. This was embodied in
new legislation governing the Central Bank in May 2001; this legislation remains largely ineffect to date.
3. Inflation targeting in practice
2001-12
Although Iceland’s inflation has in recent times been lower and more stable than in earlier
decades, the period of greater price stability actually began a decade before the 2001 adoptionof IT, when dissatisfaction with the repeated surges of high inflation led to a reform package
which included a disciplined centralised wage settlement and the announcement of a stableexchange rate regime. Despite two moderate depreciations during the ERM crisis of 1992-3,
that regime did provide a credible anti-inflation anchor (Andersen and Guðmundsson 1998).
Indeed, as the Central Bank itself has acknowledged, inflation during the IT period has notbeen satisfactory and has been worse than was hoped for when IT was introduced. In its own
evaluations, the Central Bank has concluded that IT has performed “poorly” in Iceland
compared to other countries (Central Bank of Iceland 2012; 2017a). According to the Central
Bank, the difference can be attributed to structural factors that make policy more challenging
in Iceland relative to larger and more diversified economies.
12

It is not only in the inflation record that Iceland’s macroeconomic performance in the periodof formal inflation targeting has been disappointing. In addition to the wide fluctuations ininflation and the swings in nominal exchange rates, the period has been marked by aparticularly wide fluctuation in economic activity, this time triggered not so much byfluctuations in supply or prices of export commodities but by the financial intermediation andproperty boom of the mid-2000s succeeded by systemic failure of the banking system, andsudden stop of capital inflows in 2008. The deep recession that followed was marked by a
sharp fall in output and employment. Despite the imposition of exchange controls, thesudden stop meant that the nominal exchange rate depreciated sharply during 2008. This
resulted in a surge in inflation during 2008-9 to levels that had not been seen since the 1980s.
Although the crisis of 2008-10 inevitably dominates discussion of overall economic
performance as well as inflationary trends in the IT period, it is worth noting that, before thecrisis, the IT regime had not been very successful in stabilizing inflation. Even setting aside
the teething troubles, attributed by Guðmundsson et al (2000) to having begun IT with an
overvalued exchange rate, it is noteworthy that inflation did not stay close to target for long.
After falling slightly below target in 2002-3, inflation started to rise from around 2 per cent in2004 to around 8 per cent by mid-2006 (Figure 7). It seems clear that monetary policy action
to restrain inflation was inadequate during the boom.
This is not the place for reviewing the causes of that crisis, which had important specificfeatures that are unlikely to recur and that have little to do with monetary policy. Still,
although not the main cause of the banking excesses and subsequent crash, lax monetary
policy in 2004-5 was likely a contributory factor. However, this reflected not so muchinterest rate policy but rather the challenge of controlling an exuberant environment withinterest rate policy.2 As inflation was rising, the Central Bank responded with increases of its
key policy rate, from just over 5 per cent in 2004 to over 13 per cent by end-2006 (Figure 8).
By August 2007 (when the turbulences associated with the Global Financial Crisis started)
the significant increase in real-interest rates had brought CPI inflation down to under 3.5 percent. Using an alternative measure of inflation that excludes the housing component, CPIXH,
inflation was reduced to just 0.5 per cent (Figure 7).3 The resulting high interest rates,
however, also invited unwelcome additional inflows in the form of a carry trade that
contributed to the external imbalance of the country. The current account, which was insurplus in 2002, deteriorated rapidly in subsequent years, reaching a record deficit of 23 percent of GDP in 2006.
On the other hand, when it came, the collapse of investor confidence leading to a sharp
currency depreciation at the end of 2008 was an event which the normal tools of monetary
policy could not effectively combat, and a surge of inflation followed with two years of
double digit inflation 2008-9. Indeed, it would have been a mistake for monetary policy to
try to combat the inflation surge more vigorously.

2
As we discuss later on, supplementing interest rate policy with macroprudential tools could ameliorate thisvulnerability.
3
We further discuss the discrepancy in alternative price indexes later on.

13

A monetary policy framework, however well designed, cannot on its own ensure economic
and financial stability in any country. Overall stability requires a sound fiscal policy
framework and a robust framework for supervision and regulation of the financial sector. In
the case of Iceland, most of the vulnerabilities that led to the crisis could be attributed tofactors other than monetary policy, and should not be attributed to the existence of an IT
regime.
The development of an overextended financial sector, with large cross border exposures, canbe identified as one of the key vulnerabilities that led to the crisis. This can be attributed to
the weaknesses in the supervisory framework in place before the crisis. Tighter banksupervision could have contained the pre-crisis banking boom, at least to some extent. As
discussed in numerous post-crisis analyses (e.g. Benediktsdottir et al. 2011; 2017), thefailures of bank management and bank supervision in Iceland were similar in character to anumber of failures elsewhere in the pre-crisis financial boom. But they were quantitatively
much more widespread and extreme relative to the size of the Icelandic economy.
In the aftermath of the crisis, a somewhat delayed return to the inflation target likely
facilitated the macroeconomic adjustment that took place. The inflation of 2008-9 did not
fully offset the nominal exchange rate movement, so that there was a real depreciation and areduction in real wages, helping to restore competitiveness and underpinning a recovery in
employment from 2012.
The record of IT in Iceland 2001-12 is thus a very mixed one. It cannot be credited withbringing the very high inflation rates of previous decades under control, as that had beenachieved by the early 1990s; it was not operated with any sustained success in its first six
years 2001-7; it was in abeyance in the crisis years.
Since 2012
While we do not attempt to evaluate current monetary policy decisions, the IT record since2012 seems much more positive. With the main elements of the necessary immediate postcrisis macroeconomic adjustment accomplished, the IT framework resumed its role ofproviding a long-run anchor that led to a return to price stability within a few years at asmaller economic cost than would have materialized had the exchange rate not been allowed
to adjust in the crisis environment.
Inflation has been close to target for four years. Expectations for future inflation, whether
measured by surveys or by the difference between the yields on indexed and non-indexedbonds have also converged on the target. The Central Bank’s 2017 self-assessment on theeffectiveness of IT also points to a number of other indications that the dynamics of inflation
are much better under control than was the case pre-crisis. Furthermore, it is not just afavourable situation on the inflation front. The economy is showing strong growth in output
and employment; unemployment is returning to low levels despite strong immigration.
House prices have recovered almost to their pre-bust levels. The authorities chose to remove
controls on capital outflows in early 2017.

14

Of course not all of the improvement is attributable to monetary policy. A vigorous
expansion of tourism, perhaps in part supported at first by the improved pricecompetitiveness, has boosted the recovery, and helped eliminate the current account deficit in
the balance of payments. The net fiscal costs of the banking collapse have been largely
eliminated (thanks in part to various taxes and “solidarity contributions” paid by the foreign
investors including the estates of the failed banks); the public finances had been placed on asound footing by 2017.
With inflation on target and apparent balance in the main macroeconomic indicators, themain questions that are raised now in relation to monetary policy relate to side-effects: highinterest rates and a currency that appreciated rapidly during 2013-7, producing a realexchange rate approaching levels that were previously associated with overvaluation crises.
These two elements are not unrelated: high interest rates underpinned the substantial recovery
in the exchange rate.
It is possible to look at the last few years’ developments in interest and exchange rates andinflation from a different perspective to that of straightforward IT. Indeed, financial
developments in the past few years have also been influenced by the arduous process ofnegotiating settlements around frozen foreign holdings of Icelandic assets and theliberalization of capital controls. In this context high interest rates served a separate function,
additional to their monetary policy role under IT, to help rebuild official foreign exchange
reserves and to guard against renewed currency weakness when controls were removed.
From this perspective, the high interest rates and currency appreciation could be seen as sideeffects of the policy tools being used to ensure an orderly removal of controls. The
dampening effect of currency appreciation on inflation could, from that point of view, be seen
as a helpful side-effect.
In reality both policy objectives, IT and safe removal of controls, converged on the same
choice for policy instruments; it does not much matter now which goal was dominant.
What does matter is that the IT framework retains credibility, as is inferred from market
expectations about future inflation, and that the Central Bank has the tools to implement it.
The current and future environment for monetary policy differs significantly from that whichprevailed during 2012-2016 inasmuch as the exchange controls are largely removed. This
makes the Icelandic economy more vulnerable to short-term fluctuations in internationalflows, but it does not per se call for a different institutional approach to monetary policy.
Indeed, the arrangements currently in place largely parallel what is in place in most otherinflation-targeting countries open to capital flows.
4. The current institutional arrangements for monetary policy
On 27 March 2001, the Government of Iceland and the Central Bank of Iceland decided tochange the framework on monetary policy and issued a declaration that transformed Iceland
to an inflation targeting country. The primary objective of monetary policy would be price15

stability, defined as an annual inflation rate of about 2 ½ per cent. The Government granted
full authority to the Central Bank to use its instruments to attain the inflation target.
In May 2001, the Parliament enacted a new Central Bank Act that incorporated these changes
and formalized the new framework. Two critical changes in the law were the clarificationthat the Central Bank’s primary objective would be price stability and the operational
independence given to the Central Bank. According to Article 3 of the 2001 Act:The main objective of the Central Bank of Iceland is to promote price stability. By
agreement with the Prime Minister, the Central Bank can declare a numerical target for
inflation.
The Central Bank shall promote the implementation of the economic policy of theGovernment as long as it does not regard it to be inconsistent with its main objective as
described in Paragraph 1 above. (Central Bank of Iceland, 2001. p. 40.)
The change from the multiple-objective language of Article 3 of the 1986 Act reflected theglobal consensus that had emerged during the second half the 20th century that monetary
policy can best contribute to overall economic well-being by preserving price stability overtime. While the importance of other policy goals is recognized, these are to be pursued
without compromising price stability.4
The most important change in the law was the granting of operational independence to theCentral Bank. Crucially, the clause in Article 4 of the 1986 Act which directed the Bank “toimplement such policy as the Government ultimately lays down” was removed. In addition,
the risk of monetary financing was removed. According to Article 16 of the new Act: “TheCentral Bank of Iceland may not grant credit to the State Treasury, municipalities or
Government institutions other than credit institutions.”
In principle, the Central Bank of Iceland could have adopted IT on its own even without achange in Article 3 of the Central Bank Act, as long as it was granted operational
independence.5 Nonetheless, changing Article 3 was a positive step. The additional clarity
and accountability provided by acknowledging the primacy of price stability as a monetary
goal is a more robust framework for ensuring monetary stability.

4
The priority given to price stability in the mandates of most central banks today reflects two key
considerations: first, the evidence, informed especially by the experience of the 1960s and 1970s, that long-term
growth rates cannot be successfully manipulated by activist monetary policy; second, the desirability of having ameasurable goal to help ensure accountability of an independent monetary authority. But in order to achieve
price stability, central banks all pay close attention to employment and output developments. The fact that thestatutory objectives of the US Federal Reserve are maximum employment and moderate long-term interest rates
as well as stable prices likely does not differentiate its approach to policy deliberations and decisions much inpractice from those of IT central banks.
5
For example, the Reserve Bank of Australia (RBA) adopted inflation targeting in the early 1990s even though
its mandate, as formulated in the Reserve Bank Act of 1959, was similar to that of the Central Bank of Iceland
before 2001: It instructed the RBA to “best contribute to: (a) the stability of the currency of Australia; (b) themaintenance of full employment in Australia; and (c) the economic prosperity and welfare of the people ofAustralia” (Government of Australia, 2015). The key difference was the independence of the central bank.

16

The Central Bank Act of 2001 harmonized the framework governing the operations of theCentral Bank of Iceland to that prevailing at the time in other Nordic countries and moregenerally in Europe. The two main changes in the law—operational independence and therecognition of price stability as the primary mandate of the central bank—coincided with key
provisions of the 1992 Maastricht Treaty of the European Union that had already been
adopted by all member states of the European Union. Among Nordic countries, the legal
framework for central banks in Sweden, Denmark and Finland reflected these key elements
as all three were members of the European Union. Norway, like Iceland a member of the
EEA but not the EU, adopted inflation targeting in March 2001, the same month as Iceland.
The inflation target adopted with the March 2001 declaration—an annual rate of inflation of
2½ per cent, as measured using the consumer price index—was similar to the actual andimplied inflation objectives of the central banks of other advanced economy IT countries andhas remained unchanged. The declaration also provided guidance regarding the limits offlexibility that could be applied in attaining the inflation target. Policy could be more flexible
as long as inflation moved within a range from 1 per cent to 4 per cent (also not dissimilar toranges chosen by other countries). If inflation deviated by more than 1½ percentage points
from the target, the Central Bank would be obliged to bring it back to the range “as quickly as
possible.” It would also submit a report to the Government explaining the reasons for thedeviation and the Bank’s plans for action.
The Central Bank Act was amended in 2009, creating a Monetary Policy Committee (MPC),
responsible for monetary policy decisions. The five member committee is chaired by theGovernor and has two additional “internal” (i.e. senior Central Bank staff) members, one ofwhom is the Deputy Governor. The other two members are external experts in the fields of
economic and monetary policy, appointed by the Government for five-year terms. There are
no Government representatives, again in line with what is nowadays generally consideredgood practice. As to size, about a quarter of MPCs around the world have five or fewer
members; about two-thirds have between 6 and 10. Accordingly Iceland’s MPC is on thesmall side, but not out of line with international practice, especially considering the size ofthe economy.6
The MPC meets 8 times a year (the modal frequency among leading IT central banks).
Decisions are taken by majority vote. The MPC has the authority to take decisions on all
monetary policy instruments, including especially short-term money market interest rates aswell as foreign exchange market transactions intended to influence the exchange rate.
Minutes of decisions are published two weeks after each interest rate decision and include therationale for MPC decisions. However, according to the Act, the MPC may decide not togive account of decisions on foreign exchange market transactions; in practice this has
resulted in a lot less transparency on the MPC’s policy on foreign exchange market
intervention than on interest rates. The votes of individual Committee members are made6
International institutional practice is reviewed by Hammond (2011). Blinder (2009) reviews the literature on
the performance of monetary policy committees.

17

public in the Bank’s Annual Report. Press conferences are held when monetary policy
decisions are announced.
MPC decisions are taken following an in-depth analysis of economic and monetary
developments and an assessment of risks to the outlook for inflation and the macroeconomy.
Macroeconomic forecasts are prepared by Central Bank staff four times a year. The forecasts
are judgmental but incorporate information from the Bank’s Quarterly Macroeconomic
Model which is also employed for the evaluation of alternative risk scenarios. The model
follows a conventional approach. It appears to be used by the MPC mainly as a way ofchecking the overall consistency of the policy stance; its predictions are not followed
slavishly.7 A variety of supplementary analytical approaches to selecting the optimal interest
rate path are also considered, consistent with an effort to pursue robust policies, accounting
for the unavoidable uncertainties in macroeconomic analysis. The underlying modelling is
described in some detail in a number of Central Bank publications (e.g. Danielsson et al.
2015, 2016. See also Seneca 2010).
The macroeconomic forecasts and, to a considerable degree, the additional information uponwhich the MPC’s discussions and decisions are based, are published in the Bank’s Monetary
Bulletin. Thus the MPC is briefed on a wide range of relevant economic and financial data
related to the global and Icelandic economies. This includes data on recent developments in
actual and forecast output growth and in risk premia in global financial markets; in Icelandic
tourism and other export sector output and the terms of trade; in the exchange rate for the ISK
and other currencies; house prices and household finances; the fiscal situation; sectoral output
growth; employment and unemployment trends and prospects; and then inflation and its main
components including wage costs, import and housing prices; inflation expectations.
The current framework for implementing inflation targeting is broadly consistent with thebasic practices of other IT central banks in advanced countries. The Central Bank has a clear
goal and the independence to employ the necessary instruments to achieve that goal. The
Governor and Deputy Governor and other members of the monetary policy committee havesufficient security of tenure to enable them to pursue the policy mandate free of short-termist
political pressures. Individual votes are made public, albeit with a notable lag as this is donein the Bank’s Annual Report. It is noteworthy that, as in other countries where voting is
made public, dissent by internal committee members is not uncommon: individual
responsibility is evidently assumed.
In recent years it has not frequently happened that external MPC members dissented from theGovernor’s proposal, but we have seen no indication of any reluctance out of deference on
their part to differ from the Governor. There have been suggestions that a larger timecommitment might be expected from the external members (compensated by additional
payment) and the provision of independent staff support to them. While such suggestions

7
As in most central banks, versions of the Taylor rule are also used as background guidance to the MPC’s
decisions, mainly serving as a cross-check.

18

find their parallel in the arrangements that are in place in the Bank of England, on the whole
we do not see the need for a move in this direction, taking into account the scale of Iceland.
Nonetheless, the individual accountability of MPC members could be reinforced, andpossible differences of views among committee members made more transparent bydisclosing the identity of individual votes more promptly than is presently the case. This
could be achieved, for example, by providing the individual votes in the Minutes following
each MPC meeting. The Minutes could also include a brief explanation of the rationale forany dissenting votes.
The Central Bank has a research and analytical capacity appropriate to the task and the flowof information and analysis to the committee appears to be sufficient. The Central Bank istransparent in its communications on interest rate policy with regular press conferences whenthe monetary policy decision is announced.8 There is much less transparency on policy on
foreign exchange market intervention—a point to which we return below.
One dimension in which the MPC has not followed recent trends is in the use of “forward
guidance”, i.e. making relatively specific predictions about where the policy interest rate is
likely (or intended) to be in the future. The usefulness of forward guidance and the potential
risks to credibility that it can convey have been widely debated internationally. Early uses of
forward guidance in New Zealand (as early as 1997), Norway and Sweden did seem to havebeen somewhat influential in affecting market expectations and long-term rates. Iceland has
also made some use forward guidance, albeit typically couched in broad qualitative terms.
Nothing in legislation prevents the Central Bank of Iceland from adopting forward guidanceas and when it seems necessary to influence rates but we do not see clear benefits fromchanging the Bank’s current practice in this regard.
As has been demonstrated by numerous central banks in the aftermath of the crisis, it is at thelower bound of interest rates (never approached by Iceland) that the potential usefulness of
forward guidance, including as a partial commitment device, could come into its own. It was
only at or near the lower bound that the Fed, the ECB, the Bank of England, the Bank ofJapan and the Bank of Canada have made use of it. While forward guidance at the lower
bound proved useful in providing additional accommodation by compressing longer-term
interest rates, in several of these cases, apparent commitments to future policy rates were notdelivered, showing that use of forward guidance has the potential to weaken the credibility ofcentral banks that use it, but later resile from their stated intentions.
With the exception of instances when policy rates may be constrained by the lower bound,quantitative forward guidance in the form of explicit interest paths several years out may be
misleading and counterproductive as policymakers cannot know in real time the equilibrium
real interest rate that is necessary to formulate a useful interest rate path. Indeed, real-time
uncertainty about the equilibrium real interest rate as well as related concepts, such as the8
It is suggested that the Central Bank’s policy intentions have been difficult for market participants to predict in
the period since 2011, but this is probably attributable to the volatile and fraught conditions generated by thebank failures and by the exceptional legislative measures introduced during the crisis.

19

equilibrium real exchange rate and the equilibrium unemployment rate, is why successful
implementation of inflation targeting requires attention to robustness (Orphanides andWilliams, 2007). Inflation targeting can be robustly implemented by establishing andmaintaining well-anchored inflation expectations around a clearly communicated inflation
target. This can be achieved with a strategy that is based on a forward-looking, systematic
policy response to economic developments that aims to control inflation in line with the goalin the medium term. It does not require explicit forward guidance beyond what is embeddedin the central bank’s systematic policy response to economic developments.
Following the adjustment period after the crisis, in the past few years the Central Bank of
Iceland has been reasonably successful in anchoring inflation expectations in line with its
inflation goal. Sufficient analysis is provided by the Bank so that market participants andpolicy experts should be in a position to understand its actions.
It is less obvious that the general public have a good awareness of the aims and tools of theCentral Bank: of what it is doing and why it is doing it. This, less technical, aspect ofcommunications may deserve further attention.
While there is broad agreement internationally about how some elements of monetary policy
governance should be arranged – including clarity of the goal, security of tenure for a periodof several (often 5 or more) years for the decisionmakers, instrument independence – there isconsiderable international variation of institutional details. The institutional arrangements formonetary policy in Iceland are well within the range of variation seen in successful central
banking arrangements in other advanced economies.
For example, one dimension for which there are significant differences among countries is in
the degree to which decisionmaking power is concentrated in the governor or in an innergroup of full-time staff members of the central bank, relative to external members of adecision-making committee. At one end of the spectrum is New Zealand, a pioneer in IT,
where the monetary policy decisions are taken by the Governor, albeit following an intensive
process of discussion within an advisory policy committee of staff members (of the RBNZ,
New Zealand’s central bank). In Sweden, the decisions are taken by the six-person Executive
Board of the Riksbank, with the Governor having a casting vote; the arrangement in Canada
is numerically similar. In the US, the members of the Board of Governors, when fully
staffed, outnumber the voting presidents of the regional reserve banks on the Federal Open
Market Committee; but vacancies in the Board have been frequent. In contrast, at the ECB,
the six Executive Board members are outnumbered in monetary policy discussions on the
Governing Council by 15 national central bank governors. In Norway, it is an eight-person
Executive Board that decides on monetary policy actions, though in this case five of the eight
are external members, not staff of the Norges Bank. The Icelandic regime is closest to that of
the Bank of England, where five staff members of the Monetary Policy Committee (theGovernor, the Deputy Governors and the Chief Economist) outnumber the four external

20

members.9 There is thus scope for variation but few compelling arguments that would
demand structural change in Iceland.
5. Exchange rate vs inflation targeting
The central bank’s inflation target anchors nominal price developments. While many
alternative formulations can be imagined, such as a target for nominal income growth, or forthe price level, the main competitor as a monetary policy anchor could be the exchange rate.
There is a vast literature considering the implications of different choices of exchange rate
regime for countries of different types. How sustainable will a given choice prove to be?
How likely is it to support sustained national economic growth and prosperity? 10 What is thelikely long-term impact on price stability? The fact that the world is almost equally divided
between countries that peg and countries that float is consistent with the fact that empiricalevidence on these questions is ambiguous and inconclusive—particularly on growth effects.
Our view on the realistic choices currently facing Iceland is that there is little to be gained,
and potentially quite a lot to be lost for the country as a whole, from switching from thecurrent IT regime to a fixed exchange rate regime as providing the basis of monetary policy.11
In the International Monetary Fund’s current list of the exchange regimes and monetary
policy frameworks employed by its members, Iceland is categorized as having an inflation
targeting framework with a floating currency regime. This is a categorization which it shareswith 25 other countries; a further 10 inflation targeting countries (including Norway andSweden) are seen as having a freely floating exchange rate – a distinction which recognizes
that Iceland has employed foreign exchange market intervention quite extensively in recent
times. Overall, leaving aside the 19 members of the euro area, which conduct a joint freefloat, exactly one half of the remaining 164 countries employ an exchange rate anchor – theremainder using a variety of indicators to guide monetary policy.
The fact that so many countries use an exchange rate anchor means that this alternative does
need to be considered. Closer examination of the nature of these “pegged exchange rate
countries” weakens the case. To begin with, fourteen do not have a currency of their own atall. Then, of the 31 US dollar peggers, fifteen are small states in the Caribbean or Central
America with close economic ties with the US and, with two exceptions, GDP levels afraction of that of Iceland. A further eight are in the Middle East, with its long tradition ofcurrency stability and the consideration that the international price of the major export
product—oil—is quoted in US dollars. Discarding historically poor performers leaves only
Hong Kong as an attractive model jurisdiction for Iceland among the US dollar peggers, and
it is a special case of limited sovereignty. As for the 22 euro peggers, setting aside thefourteen members of the two African CFA franc zones and three tiny island economies, we
9External members of the Bank of England’s Monetary Policy Committee are assigned specific support staff.
Different sectors, or political groupings, within a country may have different preferences over exchange rate
regimes.
11
A similar conclusion for Iceland was drawn in different circumstances by Krugman (1991a), Buiter (2000),
and Stiglitz (2001), as well as by Guðmundsson et al (2000).
10

21

are left only with EU members Bulgaria, Croatia and Denmark, and a couple of othercountries in the Balkans. (Nine countries have chosen other currencies to peg to: threeneighbours of South Africa chose the Rand; Bhutan and Nepal use the Indian rupee andBrunei the Ringitt. Nine countries use a basket peg of some sort.)
All in all, there is only a limited number of countries with successful economic and social
systems which could be considered as suitable models for Iceland to emulate. Interestingly
statistical analysis running back over a quarter century suggests that the one consistentcharacteristic that predicts that a country will peg (apart from those pegging to a former
colonial power) is lack of democracy (Klein and Shambaugh 2012, p.87).
Against this background, should Iceland consider shifting back to an exchange rate anchor,
such as it employed before the formal adoption of inflation targeting in 2001? After all,inflation had already been brought under control during the previous decade, during which
Iceland had a pegged exchange regime, albeit one allowing wide margins of fluctuation.
Several decades ago economists studied the relative advantages of fixed and floatingexchange rate as ways of insulating a country’s economic performance against shocks. The
conclusion generally depended on which markets were most likely to experience the most
severe shocks, and which prices were less likely to adjust quickly to clear markets. (Forexample, if wages are sticky, and if a major adverse shock to exports occurs, the fall in real
wages that may be needed to restore macroeconomic equilibrium and maintain full
employment can more easily be attained if there is some flexibility in the nominal exchange
rate. Other types of shock, especially those affecting asset markets, could be handled betterwith a fixed exchange rate.)
Subsequently, however, the experience of the turbulent 1970s and later shifted attention to
the feasibility of maintaining an exchange rate peg in the face of large capital movements. It
became clear that any given exchange rate peg is not forever. Just as, even in the days of the
post-war Bretton Woods system 1946-71, occasional realignments occurred, pegs tended tohold for a while before speculation about a realignment created turbulence; even if the
speculation was successfully resisted for a while, it was generally associated with highinterest rates which damaged economic activity. Exchange controls could be used to limit thevolume and speed of capital movements, but financial innovation and communications
technology increasingly eroded the effectiveness of such controls. The narrow-band ERM
1979-93 experienced almost one realignment per annum on average. Even long-standing
pegs, such as that of the African CFA zones (with the French franc), which survived for overthirty years, ended with a drastic devaluation.
While the peg lasts, a fixed exchange rate regime provides an anchor against inflation, but
this can come at the cost of having to use the interest rate to defend the peg, rather than topromote stability of the economy’s growth path.12 A peg does tend to stabilize the real
12This is an example of what is called the open economy policy trilemma, according to which there is an
inherent trade-off between having an open capital market, a fixed exchange rate and the ability to move interest
rates to stabilize the domestic economy.

22exchange rate while it is in effect, but that effect wears off after the peg has been abandoned.
And the duration of the peg must be considered to be finite. Indeed, empirically, the average
duration of a peg is about five years, and the median duration is just two years.13
If the remainder of the economy – fiscal policy, wage-formation, supply shocks – evolves ina stable manner, the duration and stability of an exchange rate peg can be prolonged, and as
mentioned this has been the experience of a few countries, most of them in the Middle East.
Several authors have promoted the advantages of a specific form of fixed exchange rate
known as a currency board. Currency board regimes were introduced first in colonial
jurisdictions as a way ensuring that the colonial administration could earn seigniorage byexchanging local currency notes backed by government securities in the metropole. The rulesof the currency board (albeit sometimes relaxed) prevented note issue exceeding the currencyboard’s reserves, thereby guaranteeing the value of the local currency notes. The currencyboard arrangement does not however address issues of bank solvency; accordingly it does notprovide any mechanism for countering a run on local bank deposits. This can make thecurrency board fragile, as Argentina found in 1991. However, the successful transition of theBaltic countries into the euro after a period of currency board operation, and the continued
experience of Bulgaria, which introduced its currency board vis-à-vis the DM in 1997, andwhich may eventually join the euro area, show that it can work at least for some time, when
there is a firm political commitment to continued currency stability. Nevertheless, it would
be unwise to assume that a currency board arrangement ensures a permanent currency peg.
From one point of view, the euro area can be considered as the limiting form of a currency
peg, with the euro itself operating as a kind of joint float against other currencies. But there
are important differences between the situation of a country in the euro area and that of acountry with an independent currency pegged to the euro. Euro area countries use the euro as
the unit of account; there is no local currency and accordingly no way of changing the peg ofthe local currency. The central banking system of the euro area has the capacity to provide
lender of last resort facilities in unlimited quantities, which is what cannot be done by apegging central bank without putting the peg at risk.
These seemingly powerful assurances against exchange rate risk delivered convergence ofinterest rates across the euro zone money and government bond markets in the first decade ofits operation. Still, the severity of the financial crisis highlighted the dependence of thisequilibrium on the willingness of the remainder of the system to support stressed sovereigns
and banks in some member states. With this willingness placed in doubt, the risk of the reintroduction of national currencies, albeit not envisaged in the European Union Treaty, began
to be priced-in.
Joining the euro area is not an option for Iceland, as membership is limited to European
Union members. A couple of small countries (Kosovo, Montenegro) and a couple of microstates (San Marino, Vatican City) facing special geographical and historical conditions haveadopted the euro as their currency; they do not have a central bank, nor do they earn
13

Klein and Shambaugh 2012, based on all pegging spells for 125 countries 1973-2004.

23

seigniorage on the currency in circulation. They can be considered as annexes to the euroarea.
If Iceland were to adopt a peg, the pattern of its trade suggests that pegging to the euro would
clearly be the best single currency choice. In 2016 some 43 per cent of Iceland’s
merchandise trade was with the euro area, a percentage which is higher than that enjoyed bysome euro area countries themselves (including Finland and Greece).14 (Only about 9 percent of trade is with the US). As far as tourism is concerned, some indication can be obtained
from the fact that more than one-in-three passengers departing Keflavik in the summer season
2017 were from the euro area (about the same as from the United States). To be sure, morecomprehensive calculations can be made to confirm that the ISK-EUR pair would indeed
have the potential to deliver maximum insulation from exchange rate shocks, but theadvantage of the euro is unlikely to be eliminated by such calculations.
Looking at the other four Nordic countries – all of them with considerably larger economies
than that of Iceland, it is interesting to note that each has made a different choice in regard toits relation with the euro area. Finland is in the euro area; Denmark, a member of the EU, hasa formal opt-out, but has pursued a policy of closing tracking the euro without deviation since
the system began; Sweden, also an EU member, should eventually join, but for the present
operates a freely floating regime; Norway, not an EU member, also has a freely-floating
currency. The proportion of each of these countries’ merchandise trade that is with the euroarea is broadly similar, ranging from 40 to 46 per cent.
Denmark’s choice, to peg to the euro, is seen as an important reference point. It can best be
explained in terms of geography, and a firm political conviction that a fixed relation to theeuro is and must remain the best choice for the country.
The Danish peg predates the euro, going back to 1982 when Danish authorities decided topeg the Danish krone against the D-mark, the currency of its largest neighbour. Given that
Denmark is a much larger (though still small) and more diversified economy than Iceland andmay be assumed to be more closely integrated in euro area supply chains, it may also be lessvulnerable to idiosyncratic shocks in the value of its exports than is Iceland. If so, theequilibrium real exchange rate of Denmark may be less volatile than that of Iceland, making
it easier for Denmark to retain a balanced economic development.
In contrast, the exposure of Iceland to sudden and large changes in its export and otherinternational earnings due to supply shocks, in the fishing industry, in aluminium smelting or
demand shocks in the tourism sector, may call for a change in the real exchange rate: that is
not easily delivered if negotiated wages are slow to adjust. Accordingly, maintaining low
unemployment may depend on having some flexibility in the nominal exchange rate.
More to the point, Denmark’s fixed exchange rate regime was forged in the very different
circumstances of the 1980s, as Danish policymakers sought to escape from the previous
failed regime of fiscal and monetary laxity. The exchange rate peg became the symbolic core
14

Indeed, adding the trade with Denmark, whose currency tracks the euro, brings the total to over 47 per cent.

24

of the new and highly successful policy. By now the Danish peg is an undisputed anchor of
their country’s macroeconomic policy. But getting to that point was not costless: it took
more than 5 years (1982-87) before the Danish krone finally landed on a permanent peg with
the DM (and later the euro) and even thereafter there were several attacks on the peg (mostrecently in 2008) which had to be fought with interest rates that were far higher than needed
to maintain full employment at the time (despite the access of Denmark in 2008 to swap
arrangements with the ECB).
Furthermore, unless Iceland decided to pursue membership in the European Union, it could
not count on mutual arrangements available to Denmark which make stability of its currency
more secure.
It might be argued for Iceland that a perfect coordination of steady fiscal policy combinedwith rapid adjustability of nominal wages to absorb any shocks that might hit the economy
would make a fixed exchange rate acceptable by ensuring that the economy was able tospeedily adjust to any shocks that might arise without resulting in unemployment or otherimbalances. In principle, a coordinated nation-wide wage agreement could deal with thissituation (cf. Holden 2016). However, neither fiscal policy nor (despite the exceptionallyhigh unionization rate of Iceland) wage setting can be safely relied upon to perform
sufficiently smoothly to absorb all such shocks (cf. Sila 2017). (Wage negotiations andbudgetary initiatives are of considerable current importance given the recent strength of theeconomy.)Furthermore, the growth in the scale and speed of international capital flows in recent years
means that few small advanced economies can be sure of the capacity to maintain a fixedexchange rate indefinitely in the face of determined speculative flows. Even the restrictionsof a currency board arrangement are no guarantee in this regard.
All in all, the difficulty of maintaining a fixed exchange rate in the face of investor scepticism(even in a currency board arrangement), and the advantages of retaining the possibility of
nominal exchange rate adjustment to help preserve full employment argue against a return toa pegged regime.
6. Potential modifications to targets, instruments and governanceThis section addresses potential modifications to the operating procedures of monetary policy
within the inflation targeting regime.
6.1 Exchange rate management
To reject the alternative of a fixed exchange rate regime is not to imply that the exchange rateis irrelevant to monetary policy. Far from it. Pass-through of inflation from exchange ratechanges to import prices to consumer prices appears to be substantial and relatively rapid(Petursson 2017). A surge or collapse in the international value of the Icelandic króna can be
expected to have a strong and fairly rapid impact on Icelandic inflation even if interest rates
and monetary conditions generally remain unchanged.
25

Indeed, the pass-through from exchange rate movements over the past decade has been astrongly influential channel both in increasing inflation immediately after the crisis broke,and in restraining inflation more recently. Relatively high interest rates, a recovery ininvestor confidence and the fillip to export earnings from the tourist boom have allcontributed to a very rapid appreciation in the exchange rate after 2012, though there was afall back from mid-2017. The movements were large. Against the USD, the ISK appreciatedby 57 per cent from early 2012 to mid-2017; by 30 per cent from early 2016 to mid-2017(and even by 26 per cent from early 2016 to early 2017). Then it fell back by 16 per cent injust 10 weeks.
What has the role of the central bank been in influencing exchange rate movements, andshould there be any change in this role? Three mechanisms can immediately be identified.
Interest rates influence portfolio flows and the gap between the equilibrium spot and expected
future exchange rates. The influence of the overall monetary policy stance on exchange rate
expectations also influences such flows. Finally, exchange market intervention by the central
bank can have a direct effect on the spot exchange rate. All three factors have been relevant
during the period of currency appreciation 2012-7. Interest rates have been held at relatively
high levels; on the other hand the CBI bought sizable volumes of foreign exchange. And
investor confidence in the future path of monetary policy (and economic policy in general)
may also have strengthened (as is argued by Petursson 2017).
Since the removal of controls on outward capital movements in early 2017 the CBI appears tohave stepped back from its previous active and largely one-way intervention strategy.
Inasmuch as that intervention was designed to build foreign exchange reserves in advance ofthe liberalization, it may be assumed that the CBI is satisfied with the results and sees no
ongoing need to continue such action, thereby ending the downward pressure which thepurchase of FX was having on the value of ISK. Instead it is understood that the CBI’scurrent exchange market intervention policy is limited to smoothing very high frequency
volatility in the exchange rate of the order of a few days.
But should it do more, within an overall inflation targeting regime? If the ISK is appreciating
at a time when inflation is above target, the currency movement can be considered helpful for
getting back to the inflation target (and conversely if a depreciation is accompanying below
target inflation). But if, for example, the ISK is appreciating at a time when inflation is
below target, should the central bank step in to buy FX? Conversely, when the ISK isdepreciating at a time when inflation is high, should the central bank be using reserves tostrengthen the ISK?
We believe that there is something to be said for a strategy that reinforces interest rate policy
through direct exchange market intervention in this way. But any approach to intervention
must recognize and take account of the inherent asymmetry in the central bank’s ability to
execute. The CB can be sure of its ability to buy FX in as large quantities as necessary,
because the local currency can in principle be created without limit. But the scale ofintervention to support the local currency is limited by the central bank’s reserves.
Embarking on an over-energetic attempt to limit depreciation of the ISK could exhaust the26reserves and end with a sharper depreciation than would otherwise have occurred, a generalloss of investor confidence and a limited scope for future intervention even to smooth highfrequency movements. Indeed, a market perception that the central bank is supporting animplicit peg can increase the risk of a speculative attack. It follows that intervention todampen appreciation of the ISK is a lot safer than intervention in the other direction.
As a complement or alternative to exchange market intervention, the authorities could
consider other forms of capital flow management to be adopted on a temporary basis whenneeded. Indeed, the current rules requiring interest-free deposits to be placed with the Central
Bank by any foreign investor purchasing certain types of asset can be thought of as an
example of such capital flow management. Administrative regulations concerning foreign
currency instruments and mismatches can also be envisaged. Administrative measures of thistype are not subject to the same asymmetry as exchange market intervention, but they havetheir own limitations. For example, re-introducing restrictions on outflows (even if for
defensible macroeconomic management reasons) risks creating a loss of investor confidence
far greater than warranted by the actual measures introduced. Administrative measures arealso prone to loopholes and various forms of evasion (as is already seen with the existing
restrictions).
Given the fact that destabilising capital flows are an ever-present risk, there might be an
additional desire to limit large exchange rate movements that are not expected to bepermanent because of their destabilizing impact on the profitability of trade. Dampening
fluctuations in the real exchange rate around its equilibrium value is a different type ofmotivation for intervention or other measures to influence the nominal exchange rate. It canbe a viable objective, even within a regime primarily driven by an inflation target.15 The
main challenge in implementing such a goal is the difficulty of knowing where theequilibrium real exchange rate lies at any given time, especially following the kinds of large
shock, positive and negative, that have been experienced by Iceland in recent years. If policy
prevents the nominal exchange rate from bringing the real rate to its true new equilibrium, theconsequence will likely be to distort inflation, and create either over-heating or recession.
A more limited and preferable strategy in this respect could be to intervene to limit rapid
nominal exchange rate changes (over a period of, say, several months) in one direction or
another, without targeting a particular level. Such a policy would slow real exchange rate
movements without preventing a gradual move to a new equilibrium. It is similar to ourunderstanding of the current policy, albeit addressed to lower frequency/longer term
movements: months rather than days. As already mentioned, such a policy should focus

15

This is similar to adding an exchange rate term to a Taylor rule. In the early 1990s, following Krugman(1991b) scholars have discussed the idea of a formal soft-margins “target zone” approach to exchange rateintervention. But few if any countries now pursue a formal or mechanical system of this type. The Reserve
Bank of New Zealand (RBNZ) announced in 2004 a currency intervention policy (which they referred to as atraffic lights approach) which can be seen as loose version of this. In practice however, this is a highly
discretionary system in which the RBNZ may intervene based on broad criteria; for example the intervention in2014 was justified by reference to an exchange rate level which the RBNZ regarded as “unsustainable andunjustified”.

27

primarily on limiting currency appreciations, accounting for the asymmetry in the risks ofleaning against a weakening currency.
All in all, direct action on the exchange rate, whether in the form of exchange market
intervention or temporary capital flow management, can be justified as a supplementarymeasure to speed achievement of the inflation target and to slow over-rapid real exchangechanges.16 Calibrating such measures requires tracking how fast and how complete passthrough of exchange rate movements are to the domestic inflation: with the rapidly changing
structure of the Icelandic economy and financial sector, these parameters are likely to bechanging over time.
Such measures are safer when they aim at restraining overvaluation. Care must be taken to
ensure that the measures are sustainable in terms of use of the limited stock of reserves, andthat they do not push too strongly against needed changes towards a new equilibrium realexchange rate.
Whereas under the present policy (of very limited exchange market intervention to counter
only high frequency movements) decisions are currently taken by the Governor underdelegation from the MPC, a more active and ambitious policy for smoothing exchange rate
movements would, of course, entail a more active involvement of the MPC. The new policy
would also need to be communicated in a more transparent manner, though without offering
hostages to market speculation.
6.2 Definition of inflation target
The housing component in the Iceland CPI is strongly influenced by movements in the saleprice of houses. Indeed, the sizable component of the index that represents the price of
housing for owner-occupiers closely tracks the sale price of houses.
The treatment of owner-occupier housing in national CPIs is a highly controversial topic
among specialists in index number theory. There are wide differences in national practiceand not much indication of convergence. The key issues arise because houses represent bothan important asset and a source of important consumption services. The price of theconsumption services is clearly something that is appropriate to be included in the CPI, but
doing so without bringing in some aspects of capital gain or loss is not something that can bedone easily or without ambiguity.
The other source of disagreement comes from the fact that CPIs have multiple uses. They areoften used as an approximation to the change in the “cost of living” for a typical household.
Such indices can also be used as the basis for compensation in the periodic adjustment ofwages or social benefits. They may be part of the contract for index-linked bonds. And, as aweighted average of the prices of consumer goods and services, they may simply be used as a
general purpose deflator of nominal prices.

16
It should be borne in mind, though, that (as the IMF never tires of repeating) capital flow management tools
cannot be a substitute for balance in the remainder of a country’s macroeconomic policies.

28

Owner-occupiers generally hold their houses for many years. How should the change in thecost of the shelter being “consumed” by such households be measured as part of the CPI?
One approach, the one used by Iceland, is to focus on the opportunity cost or “user cost” ofthe funds tied up in the housing asset.17 The main alternative is to focus instead on the rental
cost of equivalent or at least comparable properties.18
A different tack is adopted in the “net acquisitions” approach which is based on looking at thechange in the outlays required to acquire new housing.19
Statistical offices in most countries have experienced many severe practical problems ofcollecting the various elements of any given formula.
The net result is that countries have adopted widely different approaches to their CPIs. And
the choice of CPI measurement for housing has led to many actual and proposed changes inseveral countries.
As a result, the European Union has not yet included housing services at all in its main
Harmonized Index of Consumer Prices (HICP), which is used, for example, by the ECB incalibrating its monetary policy. The ECB’s objective of keeping inflation “below but close to
2 per cent in the medium term” refers to the HICP.
In the case of Iceland, differences in measures of inflation due to the inclusion of housing
services have been large (Figure 7) with meaningful consequences for the proper calibrationof monetary policy.
Leaving out housing services altogether, as with the HICP, does neglect a huge fraction of theexpenditures of households, and this is a fraction that can change considerably over time, andhas changed considerably over time in many countries not least because of long-term upward
trends in housing prices, as in Iceland.
Furthermore, the alternative of assuming that the rental market gives a sufficient guide to thecost of housing services to owner-occupiers can be challenged even in economies where therental market is deep. For example, it was argued that the scale of housing construction in
the US during the housing boom of the early 2000s – driven in part by expectations ofcontinuing price increases, had depressed rentals to a considerable extent (cf. Diewert andNakamura 2009) giving a misleading impression of actual trends in the cost of owneroccupier housing.
Since about 80 per cent of Icelanders live in owner-occupied houses, the rental market is thin,and so Statistics Iceland does not extrapolate from that market to impute a rental-equivalent17

And by Canada and Sweden.
As is done by the US and UK, though the latter also computes acquisitions and payments based housing pricemeasures (Office of National Statistics 2017).
19
Yet another measure, the “payments approach” tries to include all of the payments related to the ownership ofowner-occupier houses, including mortgage interest payments (Diewert and Nakamura 2009).
18

29

cost of housing.20 Instead, Statistics Iceland has employed an alternative method which,however, has been indicating substantial differences in the inflation rates of actual housing
rentals and imputed housing rentals (top panel, Figure 9).
As indicated, the user-cost approach employed by Statistics Iceland since 1992 (Guðnasson
and Jonsdottir 2009) is one of the standard methods used worldwide. However, someparticular features of the Icelandic approach make the resulting rate of inflation for imputed
housing rentals very similar to the growth rate of residential property market prices (bottom
panel, Figure 9). Two of these features are as follows. First, since long-term index-linked
mortgages are the standard way of financing housing, the expenditure on housing is taken by
Statistics Iceland to be influenced by the rate of return (smoothed over a 12 month period) on
indexed mortgage bonds applied to the capital cost of housing. (To be precise, it is assumed
that a proportion is equity financed and that this component has a constant 3 per cent cost.) A
consequence is that no attempt is made to deduct expected capital gains arising fromdeviations between house price inflation and the inflation of other goods and services.
Second, the capital cost is updated to the average price for the latest available three months.
Averaging over a longer-term period (as is done in other countries using this generalapproach) would dampen the impact of short-term movements in real house prices.21
All-in-all, the approach used by Statistics Iceland can be expected to provide a reasonableapproach to measuring housing service costs when averaged over a number of years.
On the other hand, brief periods of surging or falling house prices are quickly transmitted to
the Icelandic CPI even though they do not immediately impact the outlay of existing homeowners. Thus, for example, because of a rapid bounce-back in Icelandic house prices, bymore than 35 per cent in the 26 month period since August 2015, the CPI as measured
increased by 3 per cent, not far below target (which for that period would have been 5½ percent), even though other prices fell by fully 4 per cent in the same period. In other words,
existing owners of houses experienced falling prices, even though the index showed anincrease.
The implications for monetary policy are potentially important. If monetary policy ensuresthat Icelandic CPI tracks the 2½ per cent inflation rate closely at times when house prices arerising relative to the prices of other goods and services, the result will be to depress the pricetrend in non-housing well below 2½ per cent. During 2017, while average inflation measured
by the CPI was +1.8 per cent, inflation measured by an alternative index excluding housing(CPIXH) was −2.2 per cent. Had this alternative been targeted, more accommodative
monetary policy would likely have been chosen in recent times.

20
And to the extent that growth in the size of the rental market is skewed towards short-term visitor rentals (e.g.
through AirBnB) the usefulness of a rental equivalence approach may continue to be limited.
21
The negative correlation between the surge of goods and services inflation in 2008-9 and the collapse in house
prices at that time has had the effect, however, that the average volatility of Iceland’s CPI over the past thirty
years was actually less than it would have been had the averaging of house price movements been done over along period.

30

To the extent that such a surge in relative house prices is very unlikely to be sustained, it may
be a mistake for monetary policy to try to push down the price level of other goods simply inorder to stay on track for the total CPI index. When house price inflation slows, they will
have to change course in order to bring an end to the declining trend in other prices. In otherwords, if house prices are seen as particularly volatile, there is a case to be made for targetingan index which is free of such volatile components.
More generally, targeting a measure of inflation which includes a large component which isessentially an asset price runs against the consensus among monetary economists that argues
that interest rates should not be the primary instrument used to restrain asset price bubbles(Turner 2017 provides references). Even if some degree of leaning-against-the wind of anasset-price bubble can be considered appropriate and useful for monetary policy (a point
which is clearly relevant to our discussion of the relevance of the exchange rate to monetary
policy formulation), it is not clear that this is best achieved through the definition of theinflation concept used for IT.
The same type of argument can be made in favour of focusing more than is done at present ona core-inflation concept removing, for example, the impact of other volatile components suchas energy prices. Several other central banks pay a lot of attention to core inflation measures
as an input into their forecast of the likely medium-term trend in overall CPI inflation.
Although its widespread use in mortgages and in wage negotiations (even though formal
wage indexation is a thing of the past) means that any significant change in the index used forthe inflation target needs to be carefully prepared if legitimate expectations are not to beundermined, there is a case for moving from the current definition of CPI to one which is lesssensitive to short-term fluctuations in house prices, or even to CPIXH. As things stand, werecommend that CPIXH should also be tracked by the Central Bank with a view to permitting
a wider transitory overshoot of the CPI target whenever housing prices are rising unusually
rapidly (and vice versa). There are several ways of formalizing such an idea.22 Although theCentral Bank does not ignore various core inflation measures in its deliberations, we aresuggesting much greater attention and public communication, in particular about the Bank’s
willingness to see transitory overshooting (and undershooting) of its target induced byunusual house price movements. However, we do not suggest the formal adoption of a policy
rule; instead deviations of the CPIXH from CPI should be evaluated with a view tomoderating the speed at which the MPC chooses to bring CPI close to target. Careful public
communication about the policy strategy in this area will be important.
This is not to preclude the use of other policy measures to restrain house price bubbles, as
discussed below.
6.3 The indexed bond market and residential mortgages
The wave of high inflation which swept through most countries in the 1970s led to theintroduction in many countries of index-linked bonds and loans. These had coupon and
22

Including the inclusion of a house price term in the Taylor rule.

31

principal amount linked to movements in some index of prices and/or wages. Index-linked
bonds have indeed become an established feature of the government bond market in thelargest advanced economies, including the US, UK, Germany and France, as well as inseveral others. They are attractive to insurance and pension funds with long-term obligations
that are themselves indexed.
A number of countries created special financial institutions to intermediate indexed funds forhousing and other specific sectors. Indexed mortgages have attractions for both borrowers
and lenders when inflation is high and uncertain. A particular attraction for the borrower isthe way in which it avoids the fact that a conventional fixed nominal amortisation payment
implies a strongly front-loaded real stream of payments when inflation expectations – andtherefore nominal interest rates – are high. (A tendency for home-buyers to opt for thecontract with the lowest initial monthly outlay, even at some cost in expected value terms,
has been noticed around the world and indexed mortgages will often qualify as the lowest
when inflation rates are high.) The attraction for the lender is the insulation from inflationinduced fluctuations in wealth.
As already noted above, Iceland’s extreme inflation experience ensured that it too began touse indexation in financial contracts. Interestingly, this really took hold at roughly the sametime as indexation was being removed from wage contracts, namely in the early 1980s,
indeed shortly before inflation was starting to come under control.23
In most countries, the demand for index-linked mortgages diminished with the decline ininflation from the mid-1980s. In this respect, Iceland is an exception, with almost 80 per centof the stock of household debt currently indexed. Indeed, during 2016 and the first half of2017 the flow of net new mortgages was almost all indexed. About a half of corporate debt
also is indexed, or exchange rate-linked (though a good deal of this relates to export-oriented
firms) (Figure 10). 24
Although there is some correlation, the real rate of return on index-linked mortgages, loans
and bonds, is not reliably linked to the central bank’s (nominal) policy rate.25 As a result, thepredominance of index-linking in mortgages and other instruments reduces the effectivenessof conventional monetary policy measures in influencing aggregate demand (Figure 8). The
extent to which this is a problem can be debated. But, considering how important the
mortgage market is in transmitting monetary policy in most countries, this institutionalfeature is of considerable importance in designing the optimal set of monetary policy
instruments. After all, the main instrument used by the Central Bank to influence aggregate
23
Jónsson (1999) suggests that the introduction of indexed financial contracts removed government’s incentive
to engineer inflation.
24
Overall at mid-2017, 40 per cent of the stock of banks’ loans are indexed, with a further 17 per centdenominated in, or linked to, foreign exchange. (Central Bank of Iceland 2017b Charts III-3; III-4; V-1 and V3). The loans issued by the state-owned Housing Finance Fund (which is the other main financier of housepurchase and construction) are all indexed.
25
In 2008, the general rate on indexed loans reached its peak of 6.3 per cent, just 280 basis points above its
lowest level; whereas the rate on non-indexed loans peaked at 21 per cent, more than 1500 basis points above its
lowest level. For more than five years now, the general indexed rate has varied only between 3.50 and 3.75 per
cent, whereas that on non-indexed loans has varied between 5.6 and 6.4 per cent.

32

demand and thus inflation is the policy interest rate. In most countries an increase in thepolicy interest rate passes through to the interest rates charged on new mortgages and otherloans; in Iceland, the transmission is weak. (In theory there will normally be some influence
inasmuch as the financial markets for indexed and non-indexed instruments are linked, but
the effect is small in both theory and practice.) As a result, larger changes in the policy
interest rate are likely to be needed to keep inflation on track when the transmission
mechanism is weakened in this way.26
Supplementing the interest rate tool with other measures directed specifically at reducing/or
increasing the volume on new mortgage lending can enable the Central Bank to stay on target
with less amplitude of policy interest rates. The kinds of policy tool that can be effective
overlap with those classified as “macroprudential” including additional capital requirements,
constraints on loan-to-value and loan (or debt)-to-income ratios and the like. Indeed, it is notaltogether possible to assess the stance of monetary policy without considering the stance ofmacroprudential policy.
Because they are the main buyers of mortgage backed index-linked bonds, the operations of
the pension funds are highly influential in setting the price and influencing the availability ofmortgage finance. They also are important sources of direct mortgage lending to pension
fund members. This is a very large and concentrated sector.27 The total assets of the pension
funds are greater than those of the banks; indeed as a percentage of GDP Icelandic pension
funds are among the largest in the world. The pension funds hold about half of the equity in
Icelandic listed companies. Relative to its size, the Icelandic pension fund sector does notseem to have been the subject of sufficiently close attention from the point of view of
efficiency and macroeconomic stability.
A relaxation of the capital inflow restrictions, when appropriate, could help increase
competition in the market for long-term index-linked bonds.28
Direct intervention by the Central Bank in this market for the purpose of enhancing theeffectiveness of monetary policy is not completely out of the question, but may not be easy to
implement effectively, given the comparative lack of international experience with thissomewhat idiosyncratic market. Nevertheless, the activities of the pension funds should
receive increased analytical attention with a view to informing any appropriate extension of
the use of macroprudential measures to these entities.

26
In Chile, an interesting comparator as it is another IT country with a high proportion of indexation in thefinancial system and a large pension fund sector, the Central Bank has operated in the markets for both nominal
and index-linked securities, though (since 2001) its policy rate is the nominal rate.
27
The three largest pension funds account for more than half of the total assets of the sector. The banking sector
is even more concentrated with the three banks designated as systemically important (Arion, Íslandsbanki andLandsbankinn) accounting for over 95 per cent of the total assets of the deposit money banks. Íslandsbanki andLandsbankinn are almost fully state-owned.
28
Clearly there can be a tension between the desirability (on the one hand) of removing controls to improve
efficiency and competitiveness of the bond market and (on the other hand) our recommended potential use of
macroprudential tools to dampen undue appreciation of the exchange rate from excessive capital inflows.

33

6.4 Governance of macroprudential policy
We believe that the prevalence of index-linked mortgages provides a strong reason foraugmenting the toolbox of monetary policy with the use of macroprudential tools.
This being so, consideration would need to be given to the governance around the use of suchtools. After all, macroprudential tools are used in order to protect the system fromintermediary failure which is a related, but far from identical, concern to those of monetary
policy. The micro-prudential regulator clearly must have a central role in deliberations onsuch tools. Are the existing institutional arrangements between the monetary policy
committee and the microprudential regulator for shared deliberations and decision-making
sufficient to ensure that these tools are being used most effectively in both spheres? We thinknot.
One possible solution would be to integrate the FME into the Central Bank (from whichbanking supervision was, in effect, removed in 1999). This would ensure that policy
decisions could be taken in a more integrated manner. The greater degree of policy andfinancial independence of the Central Bank could also help overcome some of the challenges
outlined in the IMF’s 2014 Report on Standards and Codes in relation to banking supervision.
Merging the two could also help resolve tensions that can arise between the Central Bank and
FME on liquidity regulation.
Such a move might be resisted on the grounds of it concentrating more power in the Central
Bank. However, there is much to be gained from an enhanced efficiency of macro andmicro-prudential regulation and supervision. The role of Government could be protected bycontinuing the operation of the Financial Stability Council, which is chaired by the Ministerof Finance and Economic Affairs.29 The legislation authorising general prudential powers
could provide that proposed expansions in the macroprudential toolbox would be subject to a
non-objection procedure in parliament. More generally, there would need to be assurance
that accountability of the Central Bank in such an expanded role would be no less than thatwhich applies now to FME.30
Designing appropriate governance structures within the Central Bank to deal effectively withthe enlarged responsibilities needs care. Decision-making in prudential regulation andsupervision differs in substance and style from monetary policy decision-making, as it
involves far more detail relating to persons, models, transactions and procedures of individual
regulated entities. Ensuring that there is a coherent distinct decision-making governance forthese prudential matters, without creating a “silo” structure that impedes the flow of
information within the enlarged central bank, is not straightforward. There would need to be

29
Consideration could also be given to reassigning ministerial responsibility for the Central Bank from thePrime Minister to the Minister for Finance and Economic Affairs, as is the practice in most countries.
30
Consumer protection and market conduct are functions of the FME for which the arguments in favour of amove to the Central Bank are less strong. The current UK structure follows what is known as the “twin peaks”
model by placing these functions in the Financial Conduct Authority (FCA), an entity separate from the Bank ofEngland, whereas prudential supervision and financial stability are responsibilities of the Bank of England.

34

a Deputy Governor in charge of prudential matters in addition to one responsible forfunctions currently performed by the Central Bank.
7. Recommendations
Drawing on the analysis presented above, the way forward for Icelandic monetary policy
seems relatively clear. Much of what is in place remains appropriate for the future, even if
the existing regime was last modified in very different circumstances almost a decade ago.
Central Banking is a long game, and a degree of stability in institutional structures isdesirable to ensure that policy is not derailed by short-termist perspectives that could derail
the medium and long-term interests of Iceland. Nevertheless, policymakers need to be alert
to changing circumstances, and to adapt tools and arrangements to cope with emerging
issues.
Our recommendations are summarized in the following points:
1) There is little to be gained, and potentially quite a lot to be lost, for the country as awhole from switching from the current inflation targeting regime to a fixed exchange
rate regime as providing the basis of monetary policy.
We consider the adoption of a fixed exchange rate peg in current conditions to be hazardous.
Such pegs often offer a target which is all too easily attacked by speculators. The scale andspeed of international speculative capital movements between advance economies is such thatthey could easily overwhelm the defences available to the monetary authorities. Taking for
granted that there is no desire to return to a regime of tight capital controls on international
payments into and out of Iceland, the chances of retaining a peg for an extended period aresmall. A peg that is subject to disruptive speculative attack and periodic devaluations would
not provide the hoped-for stable platform on which to build continued economic growth andprosperity.
The example of Denmark is often alluded to in this context. But, as explained, Denmark’s
fixed exchange rate regime was forged in very different circumstances, not easily replicatedin Iceland today. Furthermore, its adoption was not costless. Unless Iceland decided topursue membership in the European Union, it could not count on mutual arrangements
available to Denmark which make stability of its currency more secure.
2) The 2½ per cent inflation goal is broadly in line with global practice among advanced
economies (though 2 per cent is more common) and we do not find compelling
reasons to modify it going forward.
While the restoration of financial and price level stability cannot solely be attributed to the
pursuit of the inflation target over the past decade, the target nevertheless provided a clear
and well-understood goal. Financial market participants, businesses and trade unions allunderstood what the path of inflation was intended to be on exit from the exceptional
conditions (including notably the capital controls). This helped anchor expectations. Even if
the authorities may have been a little fortunate in the way in which the confluence of external
and internal conditions helped get inflation so close to target as the capital controls were35

being removed, this does not mean that the target was irrelevant, nor that maintaining a pathclose to target will be more difficult in the future.
Viable alternatives to a 2½ per cent target are imaginable, but none offer significant
advantages to Iceland at present, and moving to any of them would incur some cost of
weakening the credibility of the existing target.
For example, recent international academic discussions contemplate whether a somewhat
higher target, such as 4 per cent, if adopted more generally, might help make monetary policy
more effective whenever there is an economic slump that has brought interest rates below
zero to their lower bound. But few central banks are seriously entertaining such ideas. Given
its troubled history with too-high inflation, Iceland should avoid being a first-mover in any
such trend.
Another alternative is to couch the price stability goal in terms of a range (e.g. between 1 and
4 per cent) without mentioning a point target. Even if such a change might be thought tofocus accountability of the central bank, it risks blurring the clarity of the goal and making
inflation expectations less-well anchored, thereby leading to worse price stability andeconomic stability outcomes. The current framework, with a monitoring range specified inaddition to the 2½ per cent inflation target is preferable.
All in all, we recommend no change in the inflation target (apart from what is implied in our
discussion regarding housing prices in recommendation 7 below).
3) The composition and governance of the Monetary Policy Committee, including
processes concerning economic analysis and forecasting, are satisfactory.
Following the pioneering example of the Bank of England, the inclusion of external, nonexecutive, members of monetary policy committees has become increasingly used in thecentral banks of advanced economies, though is still far from universal. A committee
operating with individual accountability and external members reduces the danger of groupthink and can somewhat dilute the concentration of decision-making power in the Governor
and full-time, internal, colleagues. Nevertheless, it is clear that agenda-setting and the main
formulation of the policy thrust remain with the Governor and staff.
Possible variants on the precise model employed by Iceland could include (i) having one or
two additional members; (ii) expecting a higher time commitment of external members thanat present (accompanied naturally by correspondingly higher remuneration); (iii) provision ofstaff analytical resources to support each external member. These variants correspond to the
British model. It is not clear what problem such suggestions are likely to solve. The maindrawback of each of them is the risk of over-complicating the policy discussion in what is,after all, a much smaller and simpler economy and financial system than that of the UK.
Overall, there has been no compelling reason for change, though we accept that any changes
in the three directions mentioned would be unlikely to damage the quality of decisionmaking.

36

The enhanced importance and role of the Central Bank in the use of macroprudential tools asa means of stabilizing the macroeconomy could, however, lead to a wider agenda andadditional complexity in the deliberations of the MPC. This could potentially warrant anincrease in the number of members from 5 to 6, which would be closer to the global mode.
4) The identity of individual votes in MPC decisions, with a brief explanation of therationale for dissenting votes, could be provided with the Minutes that are publishedfollowing each MPC meeting.
At present, individual votes on MPC decisions are made public with considerable lag, in the
Bank’s Annual Report. Although we are satisfied that the conduct of the MPC discussions
has been sufficiently open and accommodating of different opinions with the current practice,the individual accountability of MPC members could be reinforced, and the diversity ofviews among committee members made more transparent by disclosing the identity of
individual votes, and the rationale for dissenting votes, more promptly than is presently thecase.
Some central banks disclose this information in the announcement that accompanies MPC
decisions and this possibility could also be considered for even greater transparency. On theother hand, the analysis and details regarding the discussion that is provided in the Minutes
which are published two weeks after each MPC meeting provide a more complete context.
5) As monetary policy is fully normalized from the crisis, the central bank could direct
more effort towards explaining its strategy for both interest rate as well as exchange
rate policy to the general public.
Monetary policy actions are not always popular among the general public. It is therefore vitalthat communication is continuously maintained to maximise the degree to which the generalpublic understand what the Central Bank is doing and why its actions are in the public
interest.
Transparency of monetary policy in Iceland is good inasmuch as the underlying information
used by the monetary policy committee and the policy decisions being made arecommunicated to technical specialists among the market participants in sufficient detail andin language that seems less complex than that employed by many other central banks. Whatis less clear to us is whether the general public are as well-informed as they might be about
the nature of the decisions and operational goals of monetary policy and how they areintended to affect prosperity of the Icelandic people. It would be worthwhile to examine
what more could be done to improve communications with the general public. For example,
public concern about exchange rate movements during 2017 may not have been met with asmuch explanation as could have been helpful.
The nature of this task is different to what was needed as the authorities struggled to recoverfrom the crisis. It might need an overhaul of the central bank’s communications strategy, andmight also require a more active engagement of the central bank with the public.

376) A strategy of direct exchange market intervention could complement interest rate
policy towards dampening real exchange rate fluctuations while maintaining pricestability, but any such approach must recognize and take account of the inherent
asymmetry in the central bank’s ability to execute. While it may be advisable to leanagainst currency appreciation by purchasing foreign reserves, the scope for limiting
currency depreciation through interventions is much more limited.
Our suggestion on exchange rate policy is the most delicate of our recommendations. As
already stressed, we are opposed to the idea of a fixed peg. At present, since the removal of
most of the capital controls, exchange market intervention has been very limited and focusedon removing only high-frequency surges. We acknowledge the danger that a more energetic
exchange rate policy risks derailing the main focus on an inflation target. But we do notthink that inflation targeting in a small economy need be accompanied by exchange rate
fluctuations of the magnitudes seen in 2017.
While it may occasionally be appropriate to intervene to push against an exchange rate thathas manifestly moved well outside any realistic equilibrium range, the main objective of
exchange rate policy should be to reduce the short and medium term volatility of theexchange rate. The equilibrium real exchange rate varies over time and cannot be accurately
known in real time so attempting to do more, for example use the level of the exchange rate
as an implicit target, would likely prove counterproductive.
Designing a workable policy that leans against unnecessarily large exchange rate movements
is not an exact science. Any precise formula risks inviting speculative attack just as a fixedpeg does, especially if it is publicly announced. That is why countries that use policy to limit
foreign exchange rate movements rarely publicize their exact goals or instruments.
Exchange market intervention is not the only policy that can be used to influence theexchange rate. Macroprudential policies, including regulations governing foreign exchange
positions of regulated entities, can also be effective.
At present the very limited short-term foreign exchange market interventions of the central
bank are carried out on the instructions of the Governor operating under delegated powers
from the monetary policy committee. If our more energetic strategy for dampening exchange
rate fluctuations is to be pursued, its conduct should be regularly discussed as an agenda itemof the monetary policy committee, ensuring that the committee’s responsibility in this area iscontinuously exercised.
7) As currently constructed, the CPI appears to be overly sensitive to short-term
movements in house prices. We recommend that CPIXH should also be tracked with aview to permitting a wider deviation of CPI inflation from target whenever housing
price inflation registers unusual deviations from inflation of other prices.
The CPI index produced by Statistics Iceland is not out of line with accepted international
standards and does not appear to embody any unusual medium-term bias. However it isconstructed in such a way as to react very quickly to short-term movements in house prices.
38

Tracking this index closely may induce an unwanted degree of fluctuation in other prices,such as the exchange rate.
We believe that a price index that was less sensitive to short-term house price movements
than Iceland’s CPI would be better for many purposes and in particular as a target formonetary policy. CPIXH is one such index, but it errs on the other side by excluding housing
prices altogether and that would have missed the considerable increase in the relative price of
housing services over the past 15 years.
Consideration could be given to moving eventually to one of the alternative recognizedapproaches to including the cost of owner-occupation, such as rental equivalence or theacquisitions approach. But such a change would require careful statistical preparation. The
rental equivalence approach was previously rejected in Iceland because of the thinness of therental market.
Moving from one index to another will have distributional consequences because of the large
stock of indexed mortgages and of index-linked bonds contracted on the basis of the existing
CPI and against the background of a stated monetary policy target for CPI. Furthermore,
although indexation of wages is long a thing of the past, CPI expectations are an importantelement of wage negotiations. Major changes in the target of monetary policy undermine theplans made by businesses and households on the basis of legitimate expectations; for thatreason they should not be adopted lightly. (Still many drastic legislative and policy changes
had to be made in recent years in Iceland, so the barrier to yet another change may not be as
high as elsewhere).
Fortunately, even if there is no change in the index, monetary policy can take account of theexcessive volatility of the housing component of CPI by focusing also on the net-of-houseprices CPIXH. Wider deviations from the medium term intended path of CPI inflation
should be tolerated whenever CPIXH is deviating in the opposite direction. Thus, mediumterm CPI inflation would still be the basis of the target, but monetary policy should attempt tosee through the short-term house-price induced fluctuations in CPI. Operationalizing thisrecommendation would entail some complexity and should not be done in a mechanical way.
As a result, it will tend to blur the clarity of the monetary policy objective, though not, in ourview, in an unsurmountable way.
8) Macroprudential tools should be used more energetically and systematically to protect
against overheating in the housing market and contain the risk of recurrent boom-bust
cycles.
With house prices a significant component of the CPI, surges in house prices do lead to aninterest rate response that could in principle have some dampening effect. However, thepervasive indexation of residential mortgages to the CPI means that short-term policy interest
rates are less effective in dampening housing demand than in most countries. When there is aneed to dampen aggregate economic activity, reliance on the policy rate alone is likely to be
suboptimal. This elevates the importance of macroprudential tools for macroeconomic
stabilization.
39

Borrower-related tools such as limits on the amount of high loan-to-value, loan-to-income
and debt-to-income ratios should be part of the active toolkit. Countercyclical capital buffers
should be set in close consultation with the monetary policy committee. Where necessary,
additional tools, including regulations relating to foreign exchange-denominated instruments,
should be deployed. Admittedly, such tools have not always proved to be effective, but thelimited impact of the policy rate on mortgage market conditions means that they cannot beignored. Design and effectiveness of macroprudential tools will have to be kept underconstant review.
The kind of analysis currently underpinning monetary policy decisions will be an important
input into the design and calibration of macroprudential tools. The Central Bank should
therefore continue to be the main agenda setter for macroprudential decisions and its
proposals (to the FSC – as discussed below) on these matters should be integrated with the
MPC’s discussions. Thus, even if the macroprudential instruments are not explicitly part of
the MPC’s toolbox, the Central Bank will have a strong influence on these instruments and its
recommendations can be fully consistent with the MPC’s policy strategy.
9) Monetary policy and the prudential regulation of financial firms should be moreclosely integrated. In practice, the most promising way of doing this would entail amerger of the Central Bank with the micro-prudential regulator.
Several considerations point in this direction. Because of the strong influence of micro
prudential policies on the functioning of the financial sector, and on the effectiveness ofmacroeconomic stability policy in general, it is vital that there be sufficient smooth and open
communication between the central bank and the micro-prudential financial regulator.
Besides, Iceland’s institutional capacity to foresee and deal with emerging risks would be
strengthened if the closely related expertise required for the monetary policy and prudential
regulation functions were pooled.
The important role of the pension funds in the housing market and more widely ininfluencing macroeconomic and financial conditions implies that their activities deserve more
attention from those charged with macroeconomic stability than currently appears to be thecase. Integration of microprudential supervision of these firms in the central bank would
assist in improving this dimension of policy.
While there are several traditional arguments for the retention of separate agencies forprudential supervision and monetary policy, including concerns that regulatory power might
be too concentrated in an integrated agency, the experience of the financial crisis has shifted
expert opinion towards integration in many of the countries which had previously separated
these functions. The UK moved prudential regulation into the Bank of England and the euroarea created the Single Supervisory Mechanism within the ECB for the prudential regulationof banks. The small size of the Icelandic financial sector and administrative structures
suggest an even stronger case for integration here.

40

An integrated agency could be led by a Deputy Governor, charged with oversight of financial
supervision with specific statutory microprudential powers, who could also become an
additional member of the Monetary Policy Committee.
10) Governance of macroprudential policy should be strengthened by the inclusion of arequirement that recommendations by the Central Bank to the Financial Stability
Council that are not adopted must be made public within a short time-frame.
If macroprudential policy is to be more actively used to support macroeconomic stability as acomplement to monetary policy, its governance structures deserve special attention.
Inasmuch as many macroprudential policies entail significant political controversy, there is aconstant danger of policy inertia. The key role of the Minister for Finance in the existing
governance arrangements in Iceland (as in many other countries) provides some assurance of
democratic legitimacy for the policy actions taken, but is also likely to be the source of any
bias towards inertia. This could be alleviated by reinforcing the role of the Central Bank as
agenda setter in this domain. A requirement to publicize the Central Bank’s proposals could
help counter such a bias.
An alternative governance arrangement which could also be effective in reducing the bias toinertia might be to assign responsibility for macroprudential policy to the Central Bank
altogether (thus excluding the Minister from the decisions), while requiring it to submit any
significant policy changes for a time-limited accept-or-reject decision by the Althing.
8. Conclusion
Following a tumultuous first decade in the 21st century, Iceland has returned to a reasonable
degree of macroeconomic stability. It is important to remain vigilant and for policymakers
not to drop their guard against the re-emergence of unsustainable or destabilising behaviour,
public or private. Taking into account Iceland’s membership in the EEA, the existing
institutional arrangements for securing macroeconomic stability, including monetary policy,
seem generally fit for purpose. However, the current framework will likely be tested incoming years, with budgetary decisions and wage negotiations in the face of a booming
economy with real wages, housing prices, and the real exchange rate having recovered or
surpassed their pre-crisis peaks. There is room for improvement towards a more robust
handling of external shocks and domestic challenges. Improvements in the objectives, tools
and governance of monetary policy should be incremental rather than drastic.

41

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44Figure 1
Inflation

45

Figure 2
Inflation and currency depreciation46

Figure 3
Inflation and Central Bank policy interest rates

47

Figure 4
Real GDP per capita and unemployment rate48

Figure 5
Real exchange rate

49

Figure 6
Inflation and inflation target

50Figure 7
Headline inflation and inflation excluding housing

51

Figure 8
Key policy rate and other nominal interest rates

Key policy rate and indexed interest rates

52

Figure 9
Inflation of actual and imputed housing rentals

Imputed rentals inflation and residential property market price growth53

Figure 10
Share of indexed and foreign exchange debt

54