A turning point
Már Gudmundsson, Governor of the Central Bank of Iceland
Chamber of Commerce Monetary Policy Meeting, Hilton Reykjavík
Nordica, 8 November 2018
Mr. Chairman, honoured guests,
Iceland Chamber of Commerce's monetary
Once again, we gather here at the
policy meeting, which for years has been held after the Central Bank has
published its autumn forecast and, in latter years, the Monetary Policy
Committee's interest rate decision.
I would like to thank the Chamber of
Commerce for continuing this tradition and for giving me the opportunity to talk
to you about monetary policy.
The economy is now at a turning point, with a strong upswing and below-target
inflation giving way to weaker growth and increased inflationary pressures.
Underpinning the progress of the past few years were, on the one hand, a vast
improvement in external conditions, which could be seen most clearly in
improved terms of trade and a surge in the number of tourists visiting the
country, on the one hand, and on the other, in economic policy that proved
successful in historical context, keeping inflation under control and ensuring that
the exchange rate of the króna was a shock absorber rather than a shock
amplifier, as has sometimes occurred in the past.
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Monetary policy was successful in bringing inflation and thereafter, inflation
expectations - back to the target after 2012, without sacrifice costs in terms of
employment. Foreign exchange market intervention and capital controls,
followed by the special reserve requirement on capital inflows into the bond
market and high-yielding deposits, insulated the exchange rate from the effects
of volatile capital movements, allowing it to develop relatively unhindered and
in line with underlying economic conditions. The advantages of a flexible
exchange rate therefore prevailed, while the disadvantages were mitigated.
This did not make for an uneventful journey, however, because even though the
equilibrium exchange rate had clearly risen, it is always subject to considerable
uncertainty at any given time, and the risk of overshooting was genuine. This
risk may have materialised to some degree, but had the above-mentioned policy
instruments not been applied, it would have materialised much more strongly,
with the associated risk of an abrupt correction later on, which could have had
adverse consequences for economic and financial stability.
This economic turning point stems from a turnaround in some of the factors that
contributed to the upswing. The global economic situation is not as favourable
to us. Terms of trade are deteriorating and not improving. The rise in tourist visits
to Iceland has slowed markedly. Therefore, as compared with the last three years,
growth in export revenues will ease considerably this year and in the years to
come. GDP growth will be lower, as will the rise in our real income as a nation,
no matter what we may decide about nominal pay increases in wage negotiations
or about how we distribute such increases. This also means that the equilibrium
exchange rate of the króna has probably fallen in the recent past, which in turn
may partially explain the recent depreciation of the króna.
The deterioration in external conditions is not good news, of course, but we must
place it in the context of the substantial improvement that has taken place in
recent years. On the whole, however, this turning point is positive in a number
of ways. The growth rate of the past few years was unsustainable, and it tested
the capacity limits of the domestic economy.
According to the Central Bank forecast published yesterday, the landing will be
a soft one. GDP growth will measure 2.6% over the next three years, close to the
average level that will allow the economy to grow without importing labour. The
positive output gap will narrow gradually and close by the end of the forecast
horizon, which is in 2021. There will be virtually full employment for the entire
period, and purchasing power will continue to rise. Inflation will rise above the
target in 2019 but then remain close to the target for the rest of the forecast
horizon, partly because the forecast assumes that interest rates will rise when
inflation does.
Some observers might say that this is too good to be true. It could turn out that
way, of course, but that would be because known or unknown risks not included
in the forecast had materialised.
There are so many things that could happen in this regard. There could be
economic policy mistakes; for instance, if the Central Bank's real rate declines
more than is justified by fundamentals, or if fiscal policy provides a similar
stimulus. Were this to happen, the output gap would remain open longer and
inflation would be higher. The correction, when it came, would be steeper, and
the adverse impact on GDP growth would be more pronounced.
The markets could undershoot or overshoot, derailing the economy at least
temporarily. External shocks could strike as a result of trade disputes or further
increases in oil prices, and indeed, the alternative scenario in the most recent
Monetary Bulletin includes just such factors. Wage negotiations could result in
broad-based pay rises far larger than the already sizeable ones provided for in
the Bank's forecast. The inflation outlook would then deteriorate, which would
call for interest rate hikes. GDP growth would weaken as a result, perhaps even
ending in a contraction.
But there is always some uncertainty in both directions, and naturally, we could
end up on the receiving end of positive shocks that improve the situation. But
under these conditions, it is likely that the risk to GDP growth is tilted to the
downside.
In this connection, it is important to remember that we have seldom, if ever, been
as well prepared for adverse shocks as we are now. Our external assets exceed
our external liabilities. Our international reserves are close to an all-time high
and are almost entirely financed domestically. Public and private sector debt has
fallen steeply relative to income in the past few years. Our banks are robust, with
high capital ratios and abundant liquidity, and the Central Bank's
newly
published stress test indicates that they can withstand much more severe shocks
than we currently consider likely. Unlike many other advanced countries, we
have considerable scope for economic policy to respond to shocks, as Central
Bank interest rates are well above zero and the government is operating at a
surplus and is relatively well positioned with regard to debt. The exchange rate
of the króna is still strong, although it has fallen in the recent term, and the real
exchange rate is estimated to be broadly as it was in late summer 2016.
All in all, it can be said that our position is still relatively good, and nothing has
yet happened to give cause for deep-seated pessimism.
Yesterday the Bank announced a 0.25% increase in its key interest rate, to 4.5%.
This rate hike was decided in view of economic developments and prospects,
including those described in the Bank's new forecast, and in view of the
considerable decline in the Bank's real rate in recent months, which stems from
rising inflation and inflation expectations. One of the factors the Monetary
Policy Committee considers when it assesses the monetary stance is the Central
Bank's real rate in terms of various measures of inflation and inflation
expectations. This is illustrated in Chart 1, which shows that the real rate was
0.8% just before the last interest rate decision. This is lower than in 2013, when
there was still a considerable slack in the economy. Of course, the progress made
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in anchoring long-term inflation expectations at the target another term for
enhancing the credibility of monetary policy - has made it possible, all else
being equal, to keep inflation at target over the medium term at lower interest
rates than would otherwise be required. But it is questionable whether a real rate
of less than 1% will suffice for an economy at or above full employment, with
inflation already above the target, with a positive output gap, and with GDP
growth that is approaching equilibrium from above.
Chart 1
It cannot be said that the interest rate hike took the market by surprise. According
to the Bank's survey of market agents' expectations, published on Monday, most
respondents expected a 0.25 rate increase before the end of the year. The share
of respondents who considered the monetary stance too loose had risen steeply
since August, reaching 40%. And bond market activity in the wake of the rate
hike did not indicate that the increase was unexpected.
Even so, the rate hike has been criticised by some of the social partners and some
politicians. This suggests that the Monetary Policy Committee did not explain
well enough that sometimes it is better to raise rates now so as to avoid a much
larger rate increase later on. In view of this criticism, I think it appropriate to
explain this more fully.
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In general, Central Bank attempts to keep interest rates as low as possible but
as high as necessary - at any given time. What that optimum level is, however,
depends on conditions, and it changes from one time to another. If Central Bank
rates deviate from this optimum, the public will bear the expense. If they are
higher than need be, inflation could fall below target and GDP growth would be
weaker than it might be otherwise. If they are lower than need be, inflation could
get out of hand and economic instability could take root. In that case, a much
larger rate hike would be needed later on. So interest rates that are too high or
too low do not come without costs to the general public.
In this instance, it should not be forgotten that household mortgages tend to be
long-term loans, and a majority of them are indexed to the CPI. If inflation is
kept at target over the long term, these mortgage rates will be lower in the long
run than they would be otherwise, even though an increase in short-term central
bank rates might sometimes be required. A rate hike in the present that is
consistent with current conditions contributes to lower interest rates further
ahead. Sometimes this happens very quickly - for instance, short-term central
bank rates rise, causing longer-term rates to fall because the rate hike results
immediately in lower inflation expectations. There are a number of examples
where a rise in central bank rates leads to lower long-term rates rather quickly.
In the speech I gave here two years ago, I showed that real interest rates have
fallen steeply in the past two decades, both in Iceland and internationally. I
pointed out that the longer inflation expectations remain at target, the longer the
propensity to save remains high, the more domestic debt levels fall, and the
longer we have a positive net external position, the longer this trend could
continue in Iceland. That still applies today.
Last Friday, the Bank announced a reduction in the special reserve requirement
(SRR) on capital inflows into the bond market and into high-yielding deposits,
which was imposed in June 2016. The SRR was lowered because the interest
rate differential with abroad has narrowed and the exchange rate of the króna has
fallen. This was fully in accord with repeated statements by the Bank; i.e., that
the premises for lowering the SRR would grow stronger, other things being
equal, as the interest rate spread narrowed and the exchange rate fell.
When the SRR was introduced in June 2016, capital flows into the bond market
had more or less clogged up the interest rate channel of monetary policy
transmission. As a result, the effects surfaced primarily in a higher exchange
rate. Because capital controls on outflows had not yet been lifted at that time, the
risk existed of an overshooting of the exchange rate, with adverse repercussions
for Iceland's tradable sector. In addition, it was considered
unfortunate, and
actually unnatural, that large carry trade positions should accumulate before
those that had entered the economy before the crash had been released. The
exchange rate of the króna was also rising, and rose even further thereafter,
because of strong tourism-generated inflows through the current account. This,
of course, had a crowding-out effect on other segments of the tradable sector. If
this had been compounded by a steep rise in carry trade-related inflows, Iceland
would have found itself in a more dangerous position, with increased risk of an
abrupt correction later on and the associated impact on economic and financial
stability. Because of the recent decline in the exchange rate, this risk has receded,
and it could even be argued that the risk is currently in the other direction; i.e.,
that excessive pessimism and self-fulfilled expectations of a further depreciation
in the króna could lead to undershooting.
Chart 2
The interest rate differential is still wide, however, as can be seen in Chart 2,
particularly the long-term differential, which has only narrowed by 1 percentage
point (and much less, if adjustments are made for CDS spreads). It would
therefore have been imprudent to lower the SRR to zero now, and furthermore,
there is limited experience of the impact of adjustments in capital flow
management tools of this type.
However, this does not change the fact that the objective is to keep the SRR at
zero whenever possible. We have said that this tool should be our third line of
defence, after conventional economic policy (including intervention in the
foreign exchange market) and conventional macroprudential tools. This is not to
say that the SRR is some sort of emergency device, as distressed economies
hardly need worry about excessive voluntary capital inflows.
The capital flow management tool, or CFM, is not a capital control in the sense
that it restricts or halts certain capital flows explicitly, as was the case during the
tenure of the comphrehensive capital controls on outflows. It changes the
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incentives for inflows the shorter the investment horizon, the stronger the
costs with it, in terms of Iceland's image and the
impact. But this brings some
effectiveness of its markets, and it would be better to do without the SRR if
possible.
This prioritisation of policy tools is consistent with the position taken by the
International Monetary Fund (IMF). The IMF has been of the view, however,
that CFMs of this type should not be applied pre-emptively. This position has
not been adequately argued, in my opinion. In this context, it should be borne in
mind that the Fund's advice to Iceland on CFMs is based on a compromise by
the IMF Executive Board in connection with the Fund's Institutional View (IV)
on this topic. This compromise was difficult and is perhaps somewhat fragile,
and therefore, the text of the IV may not be deviated from to any marked degree.
When the report from IMF staff was discussed by the Executive Board last year,
however, Iceland received considerable support with the application of the CFM.
Presumably, many saw that the CFM was not being substituted for appropriate
conventional economic policy (which the IV recommends against) but the
reverse: it was being used to make conventional economic policy possible.
The IMF does not have jurisdiction in this matter in Iceland; it can only advise.
That is not the case with the EEA and the OECD, where we still have a special
exemption from unrestricted movement of capital, and the question of whether
those institutions would view the CFM as a macroprudential tool or a capital
account restriction has not yet been put to the test.
The bottom line in all of this is that here in Iceland, we need to formulate an
independent position on this matter, based on in-depth analysis and our own
interests. In addition, these issues are garnering considerable attention
internationally at present, including in the wake of a report by the Eminent
Persons Group, requested by the G20 and presented in October 2018. In that
report, it is recommended that the IMF revisit the IV and make it more flexible
as regards CFMs like that currently in use in Iceland.
Honoured guests: I had not originally intended to speak at such length on
economic developments and prospects and monetary policy conduct, but public
discourse over the past few days changed that.
I also intended to discuss other changes that, in the long run, could be much more
important than whether interest rates are currently a few basis points higher or
lower. These changes fall into two categories. First are the changes that could
take place following the Ministerial Committee's decision this autumn to
commence work to improve the interactions between monetary policy and
financial stability policy and to strengthen the framework and architecture of
macroprudential policy and financial supervision. Second are the changes in
payment intermediation caused by technological advances, among other factors
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which, for example, have put the question of a possible electronic króna, or
rafkróna, on the agenda. I have high hopes for these changes. But discussions of
them must await another occasion.