Ásgeir Jónsson: Speech - 63rd Annual Meeting of the Central Bank of
Iceland
Speech by Mr Ásgeir Jónsson, Governor of the Central Bank of Iceland, at the 63rd
Annual Meeting of the Central Bank of Iceland, Reykjavík, 4 April 2024.
* * *
Madame Prime Minister, other Ministers, Chair of the Supervisory Board, and other
honoured guests:
"The State cannot banish inflation by decree. It cannot order that prices shall be
different than the principles of price formation dictate. Nor can it order federations of
workers and employers to negotiate labour market agreements to please itself, or
exonerate those groups of responsibility for unrealistic agreements. What the State can
and must do, however, is to administer the functions under its purview with all due
determination and steadfastness. These functions are the finances of the central
government and its many institutions, monetary policy, and trade. If the State has
sufficient control of its fiscal and monetary policy, and if it tenaciously pursues free
foreign and domestic trade and exchange rate stability, both workers and employers will
know on what grounds they can negotiate."
These were the words of Jónas Haralz in an article he wrote for the daily Morgunblaðið
on 28 November 1979, which he entitled "Turning Point". He wrote the article to follow
up a new economic policy proposal that had been introduced under the slogan "Blitzing
Inflation" during the run-up to the Parliamentary elections that were to take place a
week later. Jónas was the author of the policy, but not the slogan. The new policy
entailed tackling inflation by rapid attack: liberalising interest rates, abolishing price
controls in the domestic market, and halting depreciation of the króna A, to name a few
features, while bringing government spending into line at the same time. The proposal
was in the spirit of trends then gaining ground in the Western world. It is worth noting
that it was around this time - August 1979 - that Paul Volcker was appointed Governor
of the US Federal Reserve Bank. During Volcker's tenure, the policy interest rate in the
US was hiked to 20%, which was enough to knock inflation down from nearly 15% to
3% in the space of only two years.
For most of the 1970s, inflation in Iceland ranged between 30% and 40%. Government
leaders and Parliament spent an enormous amount of time on inflation era measures,
emergency legislation, amendments to terms and conditions, wage changes, and
shortterm economic actions that were supposed to exorcise the inflation demon, as was
commonly said at the time. But it was all for nought. The inflation demon simply gained
strength and steam. Inflation rose even further, hitting a historical peak of 60% in 1979.
On 10 October 1979, the Icelandic Government collapsed because of a lack of
consensus on the economy. The Government led by Progressive Party leader Ólafur
Jóhannesson had been in power for only one year. Its collapse came as no surprise to
Kristján Eldjárn, Iceland's president. He was prepared to appoint an extraparliamentary
cabinet under the leadership of Central Bank Governor Jóhannes Nordal. But at the last
minute - on 12 October - the Independence Party agreed to withhold support for a no-
confidence vote against the Social Democratic Party's minority Government until
Parliamentary elections could be held in December.
This was the backdrop against which Jónas Haralz' wrote the article called "Turning
Point". To make a long story short, the elections proved to be no turning point at all.
The new proposals did not gain support, as the slogan had been twisted from Blitzing
Inflation to Blitzing Living Standards. Thereafter, Jóhannes Nordal was called back to
the presidential home at Bessastaðir to discuss a possible extraparliamentary cabinet,
as he recounted in his autobiography, Lifað með öldinni [Living with the Century]. The
cabinet was not appointed, however. The Social Democratic Party's minority
Government held out for two more months, whereupon a new cabinet was formed
under the leadership of Gunnar Thoroddsen in February 1980. The new Government's
platform was quite conventional, and in fact, inflation kept soaring, reaching an
annualised rate of 130% in the first half of 1983, well into the Thoroddsen cabinet's term
in office.
Honoured guests:
A number of strategic decisions were taken in 1979 - decisions that affect us even
today. It was then that the Minister of Fisheries issued a Regulation placing catch
limitations on cod fishing, in the prelude to what we now know as the quota system. It
was then that Parliament passed legislation on production controls in the agriculture
sector, in the prelude to the quota system in that industry.
But what stands out most in my mind is that in 1979, price indexation of financial
obligations was adopted with legislation known as Ólafur's Law in April. Prime Minister
Ólafur Jóhannesson introduced the bill of legislation under his own name, as the
cabinet did not support it unanimously. He said that he had drafted it himself at the
kitchen table in his home and then walked down to Parliament with the completed
document.
At that point in time, real interest rates on bank deposits were negative by 20%,
meaning that in real terms, one-fifth of deposits were transferred from savings account
owners to borrowers each year, effectively killing off any incentive to save money - to
no one's surprise. At that time, powerful stakeholders such as the leading corporate
blocs in the country were profiting handsomely on negative real interest rates. The
same was true of young people's mortgages and student loans: they simply burned up
in the fires of inflation. The ones who lost on inflation were owners of deposits, who at
that time were mostly older people. As a result, many people who had worked hard all
their lives saw their life savings wiped out in just a few years. This transfer of wealth
was probably one of the main causes of poverty among senior citizens later on. Ólafur's
Law ensured that inflation would be impartial. It guaranteed that real interest rates
would be low but positive, but without liberalising interest rates or resorting to painful
consolidation measures to force inflation down. But the law changed Iceland's political
landscape, as no one profited from inflation anymore. Targeted measures were finally
taken later on.
To exorcise the inflation demon, it was necessary to interrupt the spiral of rising wages
and a falling exchange rate and foster faith in price stability among the general public.
The first step was taken in 1983, when a new Government under the leadership of
Steingrímur Hermannsson discontinued the indexation of wages and then liberalised
interest rates. With this, inflation quickly fell to between 20% and 30%. Nevertheless,
price stability did not have the strong anchor it needed until 1989, when the exchange
rate of the króna was pegged to a basket of currencies, interest rates were applied to
dampen demand, and the practices used for labour market negotiations were reformed.
Subsequently, it was agreed that the Government would stop financing its deficits with
overdraft loans from the Central Bank, as it had done for a long period beforehand.
Inflation dropped to single digits. But I won't go further into that story here.
Honoured guests:
The present situation is similar to that in the early 1970s in many ways. A new,
labourintensive industry - land-based freezing of fish - was introduced shortly after 1970,
concurrent with the expansion of Iceland's territorial waters. GDP growth measured
over 9% in 1972, as it did in 2022. Then, in 1973, an international energy crisis struck
and there was a volcanic eruption on Heimaey, and some 5,000 people - perhaps more
- found themselves looking for a new home. But what sets the two periods apart from
one another is that in the 1970s, the Central Bank had neither the authority nor the
independence to respond to inflation by tightening the monetary stance. The situation
today, of course, is entirely different. The Central Bank was granted independence in
2001, and the inflation target was adopted at the same time. This brought with it a
simple division of tasks: democratically elected representatives decided on an
appropriate inflation rate and then empowered the Central Bank with implementing it. I
view this division of labour as a key factor, not only for price stability but for political
stability as well.
Nevertheless, monetary policy needs political support and prudent fiscal policy. Both
Parliament and the Government must safeguard the Central Bank's independence and
ensure that the Bank can perform the role entrusted to it by law.
Inflation targeting has been highly successful in countries with a long history of
democracy, as the groundrules require transparency and public accountability, which
are compatible with the groundrules of an open society. With amendments to the
Central Bank Act that entered into force at the beginning of 2020, the Bank's
responsibilities were expanded further. The Financial Supervisory Authority merged
with the Central Bank of Iceland, and responsibility for financial stability and financial
supervision were placed under the aegis of the merged institution, alongside price
stability. These three functions support one another in the achievement of a stable
economy and financial system.
The methodology entailed in inflation targeting - which prioritises clear groundrules,
transparency, and public accountability - has been adapted to the Central Bank's other
two key objectives: financial stability, and sound and secure financial activities.; i.e.,
financial supervision. In the main, decisions on the application of the Bank's policy
instruments and the imposition of penalties are taken by three standing committees
whose members include outside experts, thereby ensuring transparency and
distribution of power. Transparency is the key to public trust and confidence. It means,
among other things, that the Central Bank's financial supervisors take action where
needed and their decisions are made public, so as to eliminate the suspicions and
scepticism that could otherwise develop - among other things. It is of vital importance to
us all that we build up a sound and healthy financial market, no matter what role each of
us may play in it.
The application of macroprudential tools can also support monetary policy by curbing
lending growth and indebtedness in the economy. This has been done successfully in
Iceland with the introduction of borrower-based measures. In the same manner, strong
supervision limits risk-taking and bubble formation in the financial system and fosters
greater resilience. The fruits of these efforts are clearly visible. The capital position of
Iceland's systemically important banks is strong, and arrears are limited despite high
interest rates, as households' and businesses' debt ratios have fallen in recent years
and are low, both in historical context and in comparison with neighbouring countries.
Honoured guests:
Monetary policy is not the only thing that has changed in Iceland since 1979. Practices
in the labour market are entirely different now. New comprehensive private market
labour agreements with a term of four years were signed this March. The new contracts
should ensure that a wage-price spiral will not develop. This alone makes them an
important element in achieving lasting price stability. They were concluded in the belief
that the Central Bank will perform its legally mandated role and ensure price stability -
hereby safeguarding purchasing power - over the term of the contracts. In fact, it is
stated explicitly in the contracts that they will be terminated if inflation is above 4.95% in
August 2025.
Inflation now stands at 6.8% in terms of the twelve-month rise in the CPI. Thus it is still
too far from the 21⁄2% target. The current inflation episode stems from the overheating of
the economy, which grew by nearly 20% in 2021, 2022, and 2023 combined - a rare
occurrence in international context. Policy rate hikes have cooled this growth down, as
figures show that domestic demand growth has eased. Even so, considerable
pressures remain. The main source of concern, though, is that short- and long-term
inflation expectations are still above the target. This gives rise to worries that the wage
rises in the most recent labour market agreements will be passed through to prices.
Added to this is an increase in Government expenditure, owing both to the wage
agreements and to the seismic activity in Grindavík, which means that up to 1% of the
country's population must now look for new housing.
The Central Bank is now obliged to ensure that inflation converges with the target within
an acceptable time frame. Otherwise, the risk is that wage agreements will not deliver
the expected purchasing power. This is why it was not a given that the policy rate would
be lowered as soon as the ink dried on the contracts. On the contrary: untimely interest
rate cuts could impede the disinflation process and result in the termination of the wage
agreements. And to quote from the Monetary Policy Committee's most recent minutes,
published yesterday, "Unambiguous indications that inflation was clearly on the decline
would have to emerge in order to make it possible to lower interest rates, and it was
important to begin the - onetary easing phase at a credible point in time."
We Icelanders cannot enjoy substantially stronger GDP growth and larger pay rises
than other countries do, and yet still have the same interest rates and inflation that they
do - it is simply impossible. In most other European countries, the problem is more
acute: persistent inflation and limited or even negative output growth.
Although many have criticised the Central Bank roundly for having hiked the policy rate
up to 9.25% in response to this overheating and inflation spike, I can assure you that
the repercussions would have been far worse if the Bank had not responded. That
would have been a journey back to the past, and one that few of us would have chosen
to take.
Individuals come and go, but the strong framework that has been created for monetary
policy and the application of that policy by the legislature and the Central Bank should
produce results comparable to those achieved by other inflation-targeting countries. We
will get results, but only if we are steadfast and disciplined and if all of us abide by the
groundrules of the policy structure we have chosen.
Honoured guests:
In 2013, the Central Bank embarked on a systematic programme of foreign currency
purchases in order to keep the króna from overshooting in the take of the tourism boom,
but also to build up non-borrowed reserves. The purchase programme remained in
place until 2017. Over that period, the Bank bought 6.1 billion euros, the equivalent of
838 b.kr. It has always been considered wise for farmers to make hay while the sun
shines, ensuring that they will have ample supplies to see them through hard times.
This principle proved its worth during the COVID-19 pandemic, when tourism industry
revenues more or less dried up overnight in March 2020 and the króna egan to
depreciate. The Central Bank responded and, in 2020 and 2021, sold currency
equivalent of 965 m illion euros, or 155 b.kr. in the foreign exchange market to support
the króna and ensure price stability. But abundant international reserves are also
important even if they lie untouched. In this case, the Biblical text about how faith can
move mountains is very apt. As an example, we can take what happened during the
pandemic - or more precisely, what did not happen during the pandemic: There was no
capital flight from the Icelandic króna, even though exports shrank by over 30%, the
largest single-year contraction in exports in the history of Iceland's modern national
accounts. The fact that there was no capital flight is doubtless due in large part to
Iceland's large international reserves and sound economic policy.
Abundant reserves are important not only for the credibility of the Central Bank, but also
for the credibility of the entire Icelandic financial system. This can be seen in the terms
offered to Icelandic firms and the Icelandic Government in international credit markets,
for instance, and in statements issued by credit rating agencies and international
institutions.
When the Central Bank buys foreign currency in the interbank market, it pays in
Icelandic krónur. All else being equal, this is equivalent to injecting liquidity into the
financial system. As a result, it was necessary to sterilise the intervention in the foreign
exchange market by, among other things, offering the banks the option of holding liquid
assets in the Central Bank as deposits. In previous years, the Bank's policy interest rate
was defined as the rate on collateralised seven-day loans. The reverse is now true. The
policy rate, or key interest rate, is now the rate on seven-day term deposits with the
Bank.
The experience of recent years has shown that using the deposit rate as a policy
instrument has resulted in very effective transmission of monetary policy to the real
economy. The problem is, though, that the application of monetary policy has changed:
instead of being an income-generating function for the Central Bank, as it was when the
Bank earned interest on loans to banking institutions, it is an expense item because the
Bank must now pay high deposit interest to financial institutions and the Treasury. To
be sure, the Central Bank does have foreign assets - mostly foreign bank deposits or
foreign government bonds - and earns interest on them. But the interest rate on those
assets is far below the rate the Bank must pay on króna-denominated deposits.
In 2023, the Bank's interest balance was negative by 9.4 b.kr. Actually, it has been
negative every year since 2015, apart from 2020, when the policy rate was historically
low. Although central banks are not profit-driven and, technically speaking, cannot
become insolvent in their home currency, their financial position does affect their
credibility. Sometimes central banks' capital has been viewed as a standard for the
value of the currency they issue. But in any event, it is clear that operating a central
bank at a loss entails a transfer of wealth into the economy. It is because of this that
there are accepted international benchmarks emphasising that central banks should
preserve their capital - partly to ensure credibility. The Central Bank of Iceland's capital
target, endorsed by the Supervisory Board by law, is 150 b.kr., but at the end of 2023
the Bank's capital was 101 b.kr. By the end of Q1/2024, it had fallen to 95 b.kr., which
puts it 55 b.kr. below the target.
The Central Bank of Iceland is not alone in operating at a loss. Most, if not all, Western
central banks currently have negative interest rate differentials, the result of large-scale
quantitative easing (QE) during the aftermath of the 2008 financial crisis. QE entails that
central banks print money by buying government bonds, and even corporate bonds and
equities. The QE policy was prevalent for about a decade, and now most leading
central banks are left with bloated asset portfolios that have tumbled in value since
interest rates started rising. Efforts to unwind these asset portfolios must be undertaken
with care in order to prevent throwing the markets into utter disarray. The excess of
liquidity prevailing in most Western countries has caused the central banks concerned
to mop up liquidity by offering deposit accounts.
This is enormously costly.
In the recent past, central banks have adopted a range of measures to strengthen their
capital position. These include capital injections from the government, increased
nonremunerated reserve requirements, special levies on deposit institutions, and
reductions in interest payments to the government. In Sweden, new legislation on
Sveriges Riksbank states that the bank shall call in capital from the government if its
capital falls below a specified minimum, so that the bank will not end up in a persistent
negative capital position, as it did in 2022. The Bank of England decided recently to
introduce an annual levy ondeposit institutions to cover the cost of its own policy
functions. This takes time and requires statutory amendment. The European Central
Bank and Norges Bank have lowered interest rates on government deposits and
increased their reserve requirements. In addition, the European Central Bank has
lowered the interest rate on required reserves to 0%.
The Central Bank of Iceland must take comparable measures in order to improve its
interest balance, and it must review the interest rates it offers to counterparties such as
the Treasury and deposit institutions, with the aim of better distributing the cost
associated with running independent monetary policy and ensuring sustainable
financing of Iceland's international reserves. In the Monetary Policy Committee
statement published this morning, it is reported that the Committee has decided to
increase credit institutions' fixed non-remunerated reserve requirement from 2% to 3%
of the reserve base. In the MPC statement, it is said that "the short-term effects of the
change should be limited. In the longer term, however, it will provide a more solid
foundation for monetary policy conduct, thereby enhancing the Central Bank's credibility
and promoting more effective monetary policy." To put this into context, the Central
Bank paid financial institutions roughly 20 b.kr. in interest on their deposits in 2023. The
need for these measures should therefore be obvious.
Honoured guests:
I began my speech today with a blast from the past - from 1979, to be specific. As I
was born in 1970, I was a strapping lad of nine in that momentous year. My father was
a farmer at Bjarnarhöfn and a regular reader of the newspaper Þjóðviljinn. My
grandfather lived next door and read Tíminn. They did not discuss politics nor swap
newspapers, though; each one read his own. I read both. But I never saw Alþýðublaðið
or Morgunblaðið. Perhaps I internalised a skewed picture of events, but in my memory it
seems as though the economy was in a perpetual state of emergency: continuous
income cuts, emergency legislation, index adjustments, and so forth. The words
"chaos" and "disintegration " are the ones that come to mind.
Ever since I became Governor of the Central Bank forty years later - in 2019 - it has
been my goal to get beyond Ólafur's Law, so to speak. By this I mean that I want
Iceland to build up a nominal interest rate system like that in other countries. There are
many reasons why broad-based price indexation creates problems for monetary policy
and for the financial system as a whole, but that discussion is too long for today.
Nevertheless, I would like to quote a report called Nauðsyn eða val? [Necessity or
choice?], issued in 2012 by Finance Iceland, then known as the Icelandic Financial
Services Association. I should also mention that I was one of the authors of the report.
The part I wish to highlight reads as follows:
"Just as the passage of Ólafur's Law ensured that no one profited anymore on inflation
through negative real interest rates, and thereby created the political will to adopt
realistic measures to bring inflation down, variable interest rates could raise the public
consciousness about the cost of inflation, thus fostering an institutional commitment to
price stability that has been sorely lacking in Iceland."
This seems to me to be a prophecy that has come to pass. Since mortgages with
variable nominal interest rates became common in Iceland after 2020, public discourse
on inflation has undergone a sea change. The fight against inflation is now a societal
priority, as can be seen in the discussions and framework for the most recent wage
agreements, as well as in political discourse. This is what is referred to in the citation as
an institutional commitment. That commitment has developed because with variable
interest rates, inflation is paid up front. Inflation comes to the fore in higher debt service,
but at the same time, the loan principal declines quickly in real terms and the borrower
builds up equity. This is what is meant by "raising consciousness about the cost of
inflation." The reverse is true with indexed loans, where debt service remains relatively
stable but inflation is added to the principal, eroding the borrower's equity position.
I also want to stress that while policy rate hikes have increased the debt service burden
on non-indexed loans, the inflation shock has not hit those loans as hard as it would
have if those loans had been indexed. This is particularly the case for borrowers who
took loans with fixed-rate clauses and have benefited from negative real interest rates -
the first time this has happened since 1979. Of course, it is impossible to maintain a
nominal interest rate system with negative real rates over a long period of time in an
environment of free price formation. Low inflation is therefore a prerequisite if variable
nominal interest rates are to be viable as a loan form. The Central Bank raised interest
rates in response to soaring inflation. It will lower them again when inflation eases.
And we are on the right path. Inflation is indeed falling, albeit more slowly than we
would have wished. I would like to reiterate that at the same time, the Central Bank has
been able to promote general stability in the financial system and the economy, despite
an enormously overheated real economy. Strong GDP growth has not been driven by
debt or by credit growth, and in real terms, households' and businesses' debt levels
have actually fallen in the recent past. Iceland's balance of payments is stable, and the
currency has been stable and supported by a current account surplus.
I am optimistic by nature, and I hope we can manage a soft landing for the economy,
but that requires that we play our cards intelligently.
I would like to end where I began - by quoting from Jónas Haralz' "Turning Point".
"Inflation will be a problem in all free societies for the foreseeable future. Keeping it in
check will require constant vigilance and drive. People cannot conquer inflation once
and for all, any more than they can manage their own lives responsibly once and for all.
The other idea is that the battle with inflation will be painless because it is quick. This is
equally far from the truth. Inflation cannot be contained without pain and sacrifice, no
matter whether attempts are made to speed up the process or drag it out. But the
rewards for the pain and sacrifice are many times greater if progress is made."
And finally, I would like to mention that Gudrún Thorleifsdóttir stepped down from the
Financial Supervision Committee earlier this year. I want to thank her for her valuable
cooperation and welcome her replacement, Erna Hjaltested.
Thank you for listening.