Birgir Ísleifur Gunnarsson: Review of economic and financial development in
Iceland in 2004
Address by Mr Birgir Ísleifur Gunnarsson, Governor and Chairman of the Board of Governors of the
Central Bank of Iceland, at the Bank's Annual Meeting, Reykjavík, 30 March 2005.
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On behalf of the Board of Governors of the Central Bank of Iceland I welcome you all to the Bank's
44th annual meeting. The Bank's financial accounts for the year 2004 have been ratified today by the
Prime Minister. The Bank's annual report has also been published. It includes a survey of the Bank's
activities and operation, along with a report on the Bank's monetary policy and actions, the financial
system, financial stability and the financial markets, and the main features of economic developments
in the course of last year.
Under the Act on the Central Bank of Iceland that was passed by Parliament four years ago, the main
objective of monetary policy is price stability. The joint declaration by the Government and the Central
Bank from March 27, 2001 set a formal inflation target for the Central Bank, i.e. it is obliged to aim at a
rate of inflation, measured as the annual twelve-month increase in the CPI, of as close to 21⁄2% as
possible. Since price stability is the Bank's main objective, monetary policy will not be applied to
achieve other economic targets such as a balanced current account, high level of employment or
specific exchange rate, except insofar as these are compatible with the Bank's inflation target.
Inflation rose in 2004 after being close to or marginally below the 21⁄2% target since the end of 2002.
The rate of inflation was 4% from the beginning to the end of the year. At the beginning of March this
year, inflation measured 4.7%, having moved above the 4% tolerance limited defined in the joint
declaration by the Government and the Central Bank from March 2001. When inflation moves beyond
the tolerance limit, the Bank is obliged to submit a report to the Government explaining the reasons for
the deviation, how the Bank intends to react and how long it will take to reach the inflation target again
in the Bank's assessment. The report shall be made public. Such a report was sent to the Government
on February 18 and published the same day.
There are a number of explanations for the recent rise in inflation. Large investments in aluminium
smelters and power sectors have built up demand pressures in the economy. These investments will
be stepped up this year, when they will peak instead of in 2006, as assumed under earlier plans.
Investment cost this year is estimated at 85 b.kr., or almost 10% of GDP in 2004. New conditions in
the credit market have also driven inflation. Plans by the Housing Financing Fund (HFF) to raise its
loan-to-value ratio and maximum mortgage amounts prompted a response from the banks, which
began offering mortgage loans on far easier terms than had been customary. So far the main impact
of increased credit supply on the price level has been through the housing component of the
Consumer Price Index (CPI). In the beginning of March the twelve-month rate of increase in housing
prices was 24%. Excluding the housing component, the CPI had increased by 2% over the same
period. Housing inflation has therefore clearly made a major contribution to total inflation in recent
months. Another cause of concern is inflation in services. Over the past twelve months, prices of
public services have risen by 6.9%, driving up the CPI by 0.5 percentage points, and private sector
services by 3.5%, adding a further 0.8 percentage points. Rising prices of private sector services have
often been an indication of mounting demand pressures.
According to estimates by Statistics Iceland, GDP growth amounted to 5.2% in 2004, on the back of
4.2% growth in 2003. Faster GDP growth was largely the result of a continued surge in national
expenditure, while exports also increased significantly after a low in 2003. Private consumption also
continued to firm up during the year with an estimated growth rate of 7.5%, the fastest for five years.
Real disposable income increased more slowly than in 2003, but private consumption was spurred by
lower mortgage debt service and easier access to credit. Investment grew by an estimated 12.8%,
somewhat less than in 2003. GDP growth in the euro area is estimated at 1.9% in 2004 and growth
prospects are lean for the years to come. This shows yet again the difference in the economic
challenges faced by Iceland and the rest of Europe, since policies there aim at stimulating the
economy, whereas Iceland's problem is to try to prevent overheating.
The widening current account deficit is also a cause for concern. Last year it is estimated at 70 b.kr.,
the equivalent of 8% of GDP. Exports increased by 12% in 2004 after being virtually stagnant in 2003.
The strong value of the króna, robust private consumption and stepped-up investments in
aluminium-related projects are reflected in substantial import growth during the year. Merchandise
imports were up by 23% in real terms, the sharpest increase since 1998. Roughly one-third of the
current account deficit may be attributed to investments in the aluminium and power sectors. The
current account deficit is forecast to widen even further in 2005, but will also peak this year instead of
in 2006, as had been forecast earlier.
Unemployment declined slowly last year despite brisk economic activity. It was not until the closing
months of the year that labour market statistics indicated mounting pressures. Seasonally adjusted
unemployment measured 2.4% in February and vacancies have soared. To some extent, growing
labour demand was met with imported labour; issues of new work permits almost doubled in 2004.
However, the number of new work permits has not increased year-on-year over the past quarter. More
labour has been imported to meet the labour requirement on aluminium and power sector projects, but
it has increased in other sectors as well.
Private sector wage settlements agreed in the first half of 2004 were broadly uniform and their cost
effect more or less consistent with the inflation target. The settlements are in force for four years but
may be renegotiated at the end of 2005 and 2006 if inflation moves out of line with the target and the
increased wage costs that they imply are not adopted across the labour market in general. This is one
example of the importance of keeping inflation as close to target as possible later this year.
When Iceland moved onto an inflation target, this involved abandoning the fixed exchange-rate regime
and allowing to the króna to float in the market. Experience has shown that, in a climate of unrestricted
cross-border capital movements, it is impossible for a central bank to control the exchange rate.
Central Bank interest rate decisions admittedly affect the nominal exchange rate, but many other
factors operate as well. Thus it is totally unrealistic to insist that the Central Bank should keep the
exchange rate at a certain level and find the right combination of interest rates and exchange rate,
whatever that may be. To do so, the Bank would either need to abandon its inflation target or impose
foreign exchange restrictions, which of course is unrealistic. After depreciating at the beginning of
2004, the króna remained fairly stable until it appreciated noticeably towards the end of the year. It
continued to appreciate in the New Year and is currently higher than it has been since early 2000.
The exchange rate of the króna has a widespread impact on the Icelandic economy. It directly affects
the prices of imports and exports of goods and services. The combined value of Iceland's imports and
exports in recent years has been equivalent to 75-80% of GDP. The real exchange rate may be
defined as the development of domestic prices or unit labour costs relative to trading partner countries,
based on a given reference year and measured in the same currency. A rise in the real exchange rate
implies that prices or labour costs in Iceland have increased by more than among trading partner
countries after adjustment for changes in the exchange rate, i.e. the competitive position of domestic
sectors has deteriorated. When it was decided to launch the large-scale investment projects for the
aluminium industry that are currently under way, it was perfectly clear that the real exchange rate of
the króna would rise considerably, as the Central Bank repeatedly pointed out in its public statements.
In particular, the real exchange rate would be driven up by a rise in the nominal exchange rate caused
by heavy capital inflows. If inflation could not be kept under control, the real exchange rate would also
increase as a result.
Thus the task has primarily involved controlling the way that developments unfold, and in the Central
Bank's view the worst path would have been if the real exchange rate had been driven up by domestic
inflation. We are familiar with such cycles from historical experience and neither businesses nor
households benefited from them. The Central Bank's approach was therefore to raise its policy interest
rate, causing a corresponding increase in the nominal exchange rate, in an attempt to prevent the real
exchange rate from rising in step with inflation. An easier monetary stance may lead to a lower
nominal exchange rate in the short run, but not to a lower real exchange rate in the long run. Lower
interest rates would eventually lead to more inflation and wage rises, which in the final analysis would
probably move the real exchange rate to broadly the same level as if monetary policy had been kept
tight from the outset. The chief difference would simply be a much higher rate of inflation when the
inevitable exchange rate adjustment arrived as the aluminium-related investments came to an end.
There is no question that the high real exchange rate has squeezed the export and traded goods
sectors, but it was known that such difficulties would emerge when the investments peak, so it should
not have come as a surprise. However, the sectors that have been affected would be in an even
tougher position with a lax monetary stance at present, which would leave us facing a much higher
rate of inflation and a strong real exchange rate at the end of this expansionary episode. Tightening
the monetary stance under such conditions could also provoke problems and shocks for the financial
system, with unforeseeable consequences.
The real exchange rate is heading for a historical high this year which is unlikely to be sustainable for
very long. It is important to engineer as soft a landing as possible. In this context I want to mention the
study in the latest Monetary Bulletin which shows that the real exchange rate is no more volatile in
Iceland than in other countries, for example other inflation-targeting countries with which we often
compare our performance. On the other hand, the importance of foreign trade varies from one
economy to the next, so exchange fluctuations have a different impact on households and business in
different countries.
According to the Central Bank Act, one of the Bank's roles is to promote an efficient and safe financial
system, including payment systems domestically and with foreign countries. I shall not dwell on
financial stability issues on this occasion. The reason is that the Central Bank will be publishing a
separate financial stability report in April which will include its assessment of the position of the
financial system. However, I would like to mention two points which are closely related to financial
stability. One is the noteworthy overseas expansion by Icelandic banks, which has major ramifications
for the financial system. Among the changes that this entails is that the banks are now less exposed to
volatility in the Icelandic economy, because of the large share of their activities that has been
transferred abroad. At the same time, they are left more prone to shocks originating in foreign markets.
This development calls for a review of the Central Bank's working procedures. I shall not go into
Monetary Bulletin
details here of possible changes, which were discussed in last autumn.
The other point is the growth in lending by the credit system, in particular by the banks. The surge in
lending over the past two years is a cause of concern both for financial stability and the Central Bank's
inflation target. Accounts of the credit system are published quarterly and the most recent statistics
show that lending by the credit system as a whole increased by 16% in real terms last year. The credit
system embraces all undertakings involved in lending activities, including the HFF and the pension
funds. The latest figures for the largest credit institutions show that domestic lending by the deposit
money banks (DMBs) grew by 40% over the twelve months to the end of February. By far the greatest
increase has been in mortgage lending. From August to the end of February the DMBs had disbursed
14,500 mortgage loans, for a total of 158 b.kr. In the opposite direction, pension funds' loans to
members contracted over the same period by 6 b.kr. and lending by the HFF by 59 b.kr. The transfer
of mortgage lending to the banking system is beneficial and will strengthen it in the long run. However,
the timing of this development during a strong expansionary phase is inappropriate. Given the way
that events have unfolded, a review of the role of the Housing Financing Fund and the legislation
governing it has become very necessary. Excluding their direct foreign operations, the DMBs' foreign
debt amounted to 1,200 b.kr. at the end of January, and had grown by 561 b.kr. over the previous
twelve months. The lion's share of this debt is long-term, which is a great improvement from the times
when the banks were overdependent on short-term borrowing for their funding. Their foreign assets
have grown as well, but not in pace with their debts. Foreign assets of DMBs amounted to 590 b.kr. at
the end of January, having grown by 312 b.kr. over the previous twelve months. Iceland's external
debt, which is largely comprised of the banks' foreign debts, is one of the weakest links in its economy.
All the agencies that issue sovereign ratings for Iceland identify this as a risk and warn that increased
indebtedness could lead to a downgrading of its credit ratings. The banks therefore bear a great
responsibility in this respect.
The only conclusion that can be drawn from the massive growth in lending by the banks is that they
have overstepped the mark. There is no question that this surge in lending is a major contributor to the
current expansionary forces in the economy, which have fuelled inflation and call for a higher policy
interest rate than otherwise. The banks are a pillar of the Icelandic economy. They insist that the
Central Bank and the Government should act with restraint and promote economic stability, so they
also have to make comparable demands towards themselves. In the long run, no economy can
sustain this huge expansion in credit that originates in the banking system.
Last week the Central Bank published its quarterly Monetary Bulletin in which it discusses economic
and monetary developments and prospects and has published its new macroeconomic forecast.
Without going into detail here, the broad finding is that robust private consumption will continue and
investment will increase, especially business investment, for reasons including that aluminium-related
projects have been stepped up for this year, as I mentioned earlier. Public consumption growth is
expected to be modest, however. GDP growth will be 6.4% this year. It will be marginally less next
year, when growth of private consumption and investment will also slow down. The positive output gap
will widen considerably this year and in 2006. This year the current account deficit will peak at 12% of
GDP, then shrink next year, contrary to previous forecasts. From all this it is clear that the economy
will be characterised by vigorous expansion this year and into 2006.
According to the inflation forecast also published in Monetary Bulletin, the outlook for inflation has
improved since the previous forecast in December but will remain above target two years ahead. The
higher policy rate and a substantial appreciation of the króna will subdue domestic demand and
dampen rises in import prices, especially in the short term. Inflation will therefore be somewhat lower
over the forecast horizon than was forecast in December. The Central Bank forecasts an inflation rate
around the 21⁄2% target one year ahead, which is lower than forecast in December. Two years ahead,
inflation is forecast at just over 3%, which is also somewhat lower than the rate forecast in December,
although still above target.
It is important to remember that an unchanged monetary policy stance and unchanged strong
exchange rate are assumed over the forecast horizon. The forecast describes the way that the Bank
considers developments are most likely to unfold if it takes no further measures than it had already
taken. Obviously, uncertainty increases over the horizon of the forecast. A particular uncertainty is the
exchange rate, which is at a historical high at present as I have discussed, posing a higher probability
that it will give way over this period and inflation will increase. In light of this forecast, at the same time
as Monetary Bulletin was published the Central Bank decided to raise its policy interest rate by
0.25 percentage points, which is a somewhat lower hike than market agents had predicted and also
less than the Bank's other recent policy rate rises. The policy rate is therefore currently 9%. Among
other things, the decision to take a relatively modest step now is based on the fact that the tightening
implied by the recent policy rate hikes and the significant appreciation of the króna have yet to be
transmitted in full. Nonetheless, further tightening may be necessary over the next few months.
Comparisons with previous forecasts and various indicators suggest that since December the Central
Bank's policy rate hikes have by and large delivered a tighter stance. The Central Bank's monetary
policy is very much debated in society at large at the moment, which is natural given the great
interests at stake. Obviously I have closely followed discussions of monetary policy for a fairly long
time and must admit that the debate in recent times has been more mature and bears witness to a
deeper understanding of economic principles than before. It is normal for opinions to be divided over
the Central Bank's measures during tight stances such as the present. The Central Bank welcomes
public debate and is ready to take part in it. I would like to use this opportunity to address a few points
that have been raised in this debate recently.
Sometimes it is alleged that monetary policy is impotent in a climate of heavy capital inflows. Claims
are also heard that the Central Bank's monetary policy measures only exert an influence through the
exchange rate and have no effect on long-term interest rates, and absolutely not on indexed interest
rates. Certainly, a tight monetary stance does put significant upward pressure on the exchange rate,
contributing to lower inflation in the short run. Central Bank policy rate hikes also have a very swift
effect on the money markets, and interest rates on other instruments with maturities of a few months
or years are soon influenced too. Central Bank policy rate decisions also have an impact on long-term
interest rates, both indexed and nonindexed. All research in Iceland and everywhere else confirms
this, but because the effect is transmitted with a long lag, monetary policy must be forward-looking.
Interest rate decisions made today are not transmitted in full to long-term interest rates until one or two
years hence. Thus the debate often focuses on the short-term effects of monetary policy, but people
need to be patient and bear in mind the impact which does not emerge until well into the future.
The Central Bank does not have the slightest doubt that interest rate changes in Iceland ultimately
have the same effect as those in other countries, in other words that general economic principles
apply just as much in Iceland as anywhere else.
When monetary tightening is beginning to have an effect and specific sectors of the economy bear the
brunt, it is normal to ask whether there are no softer alternatives, which preferably affect no one. In the
search for such approaches, it is sometimes claimed to be preferable to target liquidity through
minimum reserve requirements, rather than interest rates, or to change the composition of the CPI, for
example by excluding housing costs, which in fact would leave the rate of inflation within the target at
the moment. The Central Bank has explained its position towards both these ideas. Regarding
minimum reserve requirements, the Bank has pointed out that strong domestic financial institutions
have various possibilities for sidestepping the effects of tighter liquidity. Individual credit institutions
would therefore be affected very unequally. Such a measure would doubtless hit the savings banks
very hard, since they do not have the same scope as the commercial banks for sidestepping the
effects. International experience also shows that the impact of changes in minimum reserve
requirements is extremely difficult to predict. For individual institutions, the consequences could be
very significant. This is the main reason that none of the world's main central banks use changes in
minimum reserve requirements as a policy instrument any longer. However, even if liquidity worked,
their impact on interest rates and the exchange rate would be broadly the same as raising the policy
rate, although the transmission mechanism might be different, and they would affect individual
segments of the credit system unevenly. In addition, changing the minimum reserve requirement is not
a transparent measure and its impact on expectations is unpredictable.
The Central Bank firmly advocates that housing costs should remain part of the reference index for the
inflation target, and believes that by and large the best available methodology is being used by
Statistics Iceland to evaluate them. This is because housing costs are a major item in household
consumption in Iceland, where the level of owneroccupancy is 80%. Excluding changes in housing
prices would ignore a large proportion of household expenditures. Experience also shows that housing
inflation has the advantage, from the perspective of central banks on an inflation target, of being a
leading indicator of general inflation later on. Presumably this is because the housing market is
independent from foreign markets. Increased housing demand cannot be channelled out of the
economy, unlike various other goods and services, nor is foreign competition present to any significant
extent. When demand surges, housing prices often rise sooner and by more than prices of goods and
services in general. It may be added that if housing prices had not been included in the CPI, the rate
of inflation would have exceeded 10% in the recessionary year of 2001, which would have demanded
even tougher measures on the part of the Central Bank than were applied then.
Standard & Poor's recently upgraded its credit rating for the Republic of Iceland, which now has very
good ratings from the three main sovereign ratings agencies, i.e. Standard & Poor's, Moody's and
Fitch. All the agencies keep a very close watch on economic developments in Iceland. Because
Standard & Poor's has recently upgraded Iceland's sovereign rating, it is interesting to examine the
main points in its rationale, both the positive factors that support the rating and others that are
identified as potentially weakening it.
The agency says that its upgrade reflects significant and sustained improvements in the resilience and
structure of the Icelandic banking sector. Improved regulation and supervision leave the financial
sector much more resilient. The recent entry of the commercial banks into the Icelandic mortgage
market provides the private financial sector with additional domestic stability and profitability. Public
finances continue to be healthy and Iceland boasts stable and flexible political institutions.
However, the agency also points to very high and rising levels of net external debt throughout the
economy, high current account deficits and relatively poor external liquidity. Adherence to the
government's medium-term fiscal framework is central to maintaining the ratings and further
unforeseen adjustment would need to be accommodated through fiscal policy, not monetary policy.
Any significant increase in net external leverage or a recurrence of entrenched macroeconomic
imbalances on the back of the large investment projects could weaken Iceland's creditworthiness.
These were the main points highlighted by Standard & Poor's and there is every reason to take them
seriously. Of course it is crucial for the Republic to enjoy a good credit rating. It is important for the
Treasury's access to markets and investors, and for its credit terms. Iceland's sovereign rating also
represents the ceiling for ratings of Icelandic banks and other rated institutions. Favourable ratings are
vital for the banks' expansion abroad and for their growing need for easy access to foreign credit. Thus
the Treasury and the banks share an interest in Iceland being able to maintain its good credit rating.
Ladies and Gentlemen
As I mentioned earlier, the Central Bank raised its policy interest rate by 0.25 percentage points last
week. The Bank has thereby raised its policy rate by 3.7 percentage points since its first hike in May
last year. These measures reflect the Central Bank's view that, given the current economic situation
and the scenario two to three years ahead, it is much more effective to ensure a sufficiently tight
stance in good time rather than to wait and take action later. Belated measures to tighten the monetary
stance entail a risk of higher inflation afterwards, and thereby a far greater risk for the financial system,
businesses and households. It is crucial to take immediate measures to tackle the inflation that we see
on the horizon. This is the Central Bank's mandatory role and the Bank is determined to perform it.
The more that other economic agents contribute towards containing expansionary trends, namely the
central government, local government and credit institutions, the easier it will be to ensure long-term
stability. The successful economic policies of past years must not be swept aside in favour of
short-term solutions that would ultimately only backfire.