Monetary policy: achievements and review?
Már Guðmundsson, Governor of the Central Bank of Iceland. Monetary policy
meeting of the Iceland Chamber of Commerce, held at Harpa in Reykjavík on
17 November 2016
Madame Chairman, honoured guests,
The Iceland Chamber of Commerce has a long-standing tradition of
holding a meeting like this one on economic developments and
prospects and monetary policy. The meeting is held following the
publication of the Central Bank's autumn forecast and, in latter
years,
the Monetary Policy Committee's interest rate decision. In recent years,
it has been the practice to select a particular topic for the meeting, and
in keeping with this, today's topic is: Is independent monetary policy
too costly? This departs somewhat from the contents of the Central
Bank's
Monetary Bulletin and current tasks of monetary policy, but I
will touch on these towards the end of my speech today.
Yesterday the Bank published Monetary Bulletin 2016/4, which
contained the Bank's new
macroeconomic forecast, and announced the
Monetary Policy Committee's interest rate decision. The big picture of
the current state of the economy is that things have seldom been better.
Icelanders have received a significant boost from improved terms of
trade and growing goods and services exports, particularly due to strong
growth in the tourism sector. It is this that underlies the vast increase in
Icelanders' real income and the country's high employment level. In
addition, Icelanders have proven more cautious this time than often
before during an economic boom. Debt levels continue to fall, and the
propensity to save is considerably stronger than has usually been the
case during post-World War II upswings. This is probably due in part to
greater caution in the wake of the financial crisis, but tight monetary
policy has been a factor as well, by contributing to slower demand
growth than would otherwise have been the case and by shifting a part
of the steep rise in income and wealth towards saving. All of these
factors have pulled together to create a better balanced economy than I
have seen in my entire career. We have a handsome surplus on the
current account of the balance of payments. Inflation has been below
target for nearly three years in spite of large pay increases and strong
demand growth. Positive supply shocks and the resulting currency
inflows play a role here, and so does importation of labour. As a result,
imported deflation and the appreciation of the króna have proven
stronger than the inflationary pressures from the domestic labour
market. Monetary policy has pulled in this direction as well, as I
mentioned, and in a historically important development, inflation
expectations are close to target by most if not all measures.
If this continues, monetary policy will have greater scope to mitigate the
impact if positive developments give way to negative shocks. And
according to the Bank's baseline forecast, the outlook is good: continued
strong GDP growth and full employment; a current account surplus
throughout the forecast horizon; the prospect that Icelanders will soon
own more assets abroad than foreign nationals own in Iceland; and
inflation at target for the entire period.
One can ask, in view of this, why some observers are so dissatisfied with
monetary policy. I will discuss this in more detail later on. But there are
significant risks, and we must be on the watch for them. There is an
obvious risk of economic overheating. The labour market could spiral
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out of control. Economic policy mistakes could take place for instance,
if fiscal policy begins to pull too strongly in a different direction from
monetary policy. We have seen the repercussions of this before.
I will now turn to the main topics of my speech today: the level of
interest rates in their long-term context, the foreign exchange market,
and possible changes to the monetary policy framework.
Level of interest rates
During the run-up to the recent Parliamentary elections, there was
considerable discussion of the level of interest rates in Iceland. If we are
to come to a sensible conclusion on whether the nominal interest rate set
by monetary policy is appropriate or not in terms of inflation, inflation
expectations, the business cycle, a plausible estimate of the equilibrium
real rate, and foreign interest rates, it is important that the discussion be
based on facts. When we consider the interest rates that are most
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important for households and businesses i.e., longer-term real interest
rates rather than the rates decided directly by the Bank - it is also
important to realise to what extent monetary policy can affect those
rates. The answer to this is that monetary policy only has a short-term
impact on long-run real rates that are ultimately determined by
underlying economic fundamentals, not least the interactions between
the propensity to save and the impetus to invest.
Let us now examine a few facts of importance in this context. First, it
should be noted that international long-term real rates have been falling
over the past three decades, as can be seen in Chart 1.
Chart 1: Real long-term Treasury rates on price indexed
bonds 1985-2016
%
1985 1990 1995 2000 2005 2010
2015
- International interest -Iceland
Rates on indexed long-term Treasury bonds (5-10 years). International interest rates
are the simple average of rates for the US (from 1999), the UK, and Germany. The
Icelandic data are compiled from data on initial offerings of Treasury savings bonds
and yields on Housing Financing Fund bonds and indexed Treasury bonds. The figure
from 2016 is the average through mid-November.
Sources: Bank of England, US Federal Reserve Bank, Central Bank of Iceland.
This development began long before the financial crisis. The crisis, the
ensuing economic contraction, and the monetary easing in response to
the crisis amplified this tendency still further, and long-term real rates
are now at an absolute historical low. In part, this is related to the
business cycle position in larger advanced countries and could turn
around in coming years. However, it is unlikely that the decline in real
rates over the past few decades will reverse to any large degree in the
near future.
One of the main theories in conventional economics is that monetary
policy cannot affect real variables - including long-term real interest
-
rates except temporarily. Although this is something of a
simplification, and it is possible that monetary policy that is either far
too tight or far too loose over a long period could have more of an impact
than this, particularly in an economy with major imbalances, the theory
is nevertheless a close enough approximation under normal
circumstances to take account of it here. The period under scrutiny is
too long for monetary policy to have had a substantial impact on
developments. Furthermore, it is clear that the tendency to cut interest
rates is not limited to individual countries; it is an international pattern,
although it surfaces to varying degrees in different countries. Therefore,
the explanations will most likely be found in factors affecting the
propensity to save, the willingness to invest, and weaker growth in
potential output globally. All three of these have contributed to lower
real rates over this period, although reduced growth in potential output
might be more recent. The aging of the population, increased public
saving in emerging countries (including the accumulation of foreign
exchange reserves), and increased income inequality within countries
are among the factors that have contributed to the increase in the
propensity to save. Declining relative prices of investment products and
increased uncertainty and risk aversion, particularly during the
aftermath of the crisis, have negatively affected the willingness to
invest.
But how does Iceland fit into this picture? As Chart 1 indicates,
developments here have been similar, although interest rates have been
- -
and still are higher than in larger industrialised countries. This is
quite at odds with what could be expected based on some of the
discussion taking place in Iceland. The fact is that long-term real rates
in Iceland are currently at their lowest for this entire period, apart from
a short time in the midst of the economic crisis, when the real policy rate
was held very low so as to stimulate the economy and presumably pulled
longer-term rates downwards for a while.
I have said that monetary policy had little to do with these developments.
This does not change the fact that these developments have affected
monetary policy, as they reflect in part the decline in short-term
equilibrium real interest rates. Monetary policy has therefore responded
to this with lower nominal interest rates than would otherwise have been
appropriate. Nominal rates have fallen even further during this period,
for three reasons. First of all, inflation and inflation expectations were
brought to target levels in major industrialised countries in the last two
decades of the 20th century; therefore, it was not necessary to keep
nominal and real rates as high as before. It could be said that the same
development has taken place here in Iceland in the recent term. Second,
global deflationary tendencies have been strong in recent years,
following the inclusion of China and Russia in the global trading system
and due to technological advances and developments in international
production and value chains. Third, a pronounced economic slack in
major industrialised countries after the financial crisis has led to much
more accommodative monetary policy than would otherwise have
prevailed in those countries. All of these factors combined have
contributed to the current situation, where nominal central bank rates in
leading industrialised economies are extremely low in historical terms.
Actually, many observers consider them dangerously low as regards
their potential impact on financial stability and the efficacy of the
financial system.
What about Iceland in this context? The Central Bank's key rate is the
interest rate that determines short-term market rates at any given time.
In the recent past, this has been the rate on seven-day term deposits,
which is now 5.25%, as Chart 2 indicates. It is far below the average for
the period since the adoption of the inflation target in late March 2001,
in spite of the significant tension in the economy. This is a reflection of
the progress made in the recent term in bringing inflation expectations
to target. The Bank's key rate has been slightly lower on two occasions
since the adoption of the inflation target: in early 2011 and in early 2015.
It peaked at 18% in late 2008. It is therefore incorrect to say that the
Bank's key rate is always high, no matter what the economic situation.
Nor is it appropriate to say that the Bank's interest rates are off the charts
economic history: quite the contrary.
in the context of Iceland's
It is also interesting to compare domestic interest rates with historical
interest rates in developed countries. The chart shows that the average
of short-term nominal interest rates in the US and the UK was slightly
below 5% over the period from 1870 through 2007. This is not far from
the short-term nominal rate in Iceland at present, and it should be noted
that we are in that part of the economic cycle where the output gap is
positive, whereas the business cycle tends to average out over such a
long period as is shown in this chart. However, post-crisis interest rates
in these countries are far below their previous historical low and
therefore much more "off the charts" than Iceland's. There could be
sound reasons for this, although opinion is divided on the matter.
Let us examine Iceland's current interest rates more closely, ignoring for
the moment the problems associated with pursuing independent
monetary policy in small, open economies with unrestricted capital
flows, which I will mention later. Let us also assume that inflation
expectations remain at target, as they are at present. The question of
whether or not a nominal policy rate of 5.25% is appropriate then centres
on what is considered to be the equilibrium real policy rate; i.e., the
interest rate that would keep inflation at target when the economy is in
balance. With inflation expectations at 21⁄2%, the real policy rate is
currently just over 21⁄2%. Before the financial crisis, the equilibrium
policy rate was estimated to be quite a bit higher. As is the case
elsewhere, it has probably fallen in the wake of the crisis. Furthermore,
recent success in monetary policy may mean that we do not need as high
an interest rate as before to keep inflation at target. We do not know how
much the equilibrium rate has fallen, although the subject has been under
close scrutiny within the Bank and has been discussed repeatedly at
Monetary Policy Committee meetings. The newest research on the
assessment of the equilibrium real rate will be presented at a seminar
held at the Central Bank on 29 November.
Perhaps there will be scope in the future to lower the short-term real rate
as measured by inflation expectations somewhat further. This will
depend on developments, including exchange rate developments and the
stance of other economic policies. In addition, nominal interest rates
could change in response to developments in inflation and inflation
expectations. Under current conditions, however, it must be borne in
mind that the economy is not in balance but in the boom part of the cycle.
Furthermore, the contribution from other economic policies is uncertain
at the moment because a new Government has yet to be formed after the
Parliamentary elections and next year's fiscal budget proposal has yet to
be presented. Moreover, it is too early to say what the impact of capital
account liberalisation is. One thing is certain, however: if steep interest
rate cuts are made without being warranted by economic conditions, it
is clear that the real rate would decline for a while. But because
credibility would undoubtedly suffer as a result of poorly grounded
measures of this type, it would have to rise again, to a higher level than
before, and for a longer period than would otherwise have been needed
to bring inflation and inflation expectations back down to target.
Is it a lost cause, then, that Iceland's interest rates might with time
become similar to those in trading partner countries? Not at all. First, we
must hope, for their sake, that neighbouring countries will not need to
maintain such abnormally low interest rates for the long term. Second,
the longer we keep inflation expectations at target, maintain a current
account surplus, and continue to pay down debt, the more the risk
premium component of interest rates and the equilibrium real rate in
Iceland will continue to fall. The current propensity to save, adjusted for
the business cycle position, is much greater than it has been for quite a
while, and over time, it will contribute to a reduction in the long-term
equilibrium real rate. If inflation expectations remain at target, both
nominal and real rates will decline accordingly.
Exchange rate of the króna and Central Bank foreign currency
purchases
Responding to the recent strong inflows into the foreign exchange
the Central Bank's most complex tasks at present. The
market is one of
problem lies, among other things, in distinguishing between short-term
inflows, which are only loosely connected to economic fundamentals
and are much more likely to stop suddenly or even reverse, and inflows
that reflect more lasting positive changes in fundamentals, although
these can change for the worse as well. It can be argued that, other things
being equal, there should be more foreign exchange market intervention
in the former instance and less in the latter.
While the foreign exchange reserves were being increased to the desired
size during the prelude to general capital account liberalisation, this
distinction was less important for policy responses than it is now, as the
premises were in place to buy the inflows and top up the reserves, more
or less irrespective of the origins of the inflows. Carry trade-related
inflows into the bond market did cause some disruption of monetary
policy transmission in summer 2015 and last winter and could have
posed risks for financial stability further ahead. For this reason, and also
to prevent the development of a new "overhang" following the offshore
króna auction in June 2016, it was considered appropriate to take action
to mitigate these inflows. Since then, they have largely stopped.
However, there has been no let-up in foreign currency inflows in recent
months, and by the end of last week, the Central Bank had bought
foreign currency in the amount of 160 b.kr. since the beginning of July
and the exchange rate had risen by nearly 12% over that same period.
The available data indicate that foreign currency inflows are to a large
extent related to the trade surplus, which has been quite large, owing
partly to growth in tourism and positive terms of trade, plus foreign
investors' increased interest in direct investment in the Icelandic
economy. The banks' and other Icelandic firms' improved access to
foreign credit could play a role as well. On the other hand, speculative
flows related to the interest rate differential appear to account for only a
small part of the inflows. Another important factor is that
liberalisationrelated outflows are still limited. It should be noted, though, that balance
of payments figures for Q3/2016 could change the picture somewhat,
but they will not be available until the beginning of next month.
The Central Bank has bought a smaller share of foreign exchange
inflows in the recent past than it did earlier in the year, and the króna has
appreciated more as a result. This is because the foreign exchange
reserves are larger and somewhat above the recommended minimum for
liberalisation of the capital controls. The nature of the inflows is
important, as is the view that if the currency appreciates due to a rise in
the equilibrium real exchange rate, this is part of the desirable
countercyclical role of the exchange rate; furthermore, it is not desirable
to disconnect the exchange rate channel of monetary policy transmission
entirely. Nevertheless, the foreign currency purchases have been
substantial, based on precautionary principles concerning the durability
of the inflows and attempts to prevent excessive appreciation of the
currency in advance of liberalisation-related outflows.
In the wake of the Central Bank's large foreign currency purchases this
year, the question has arisen whether large foreign exchange reserves are
a problem in and of themselves; i.e., whether they jeopardise the Bank's
finances to such a degree that they could undermine its ability to pursue
appropriate monetary policy at any given time. We do not have time to
explore this in depth here, but the short answer is: no, they are not. First
of all, we must not focus only on the cost of financing the reserves; we
must also consider the benefits associated with them. Second, in
assessing the current size of the reserves, it is important to bear in mind
that the impact of general liberalisation of capital controls seems,
fortunately, to come to the fore gradually, although this does not mean
that it couldn't become significant going forward. Large reserves
generate confidence during this process. Third, we should not project
current conditions to the infinite future and therefore come up with a
huge problem. The monetary stance changes over the course of the
business cycle, as is normal, and the interest rate differential with abroad
varies from one point in time to another. Furthermore, there are
fluctuations in foreign currency flows and exchange rates, and the
opportunity could arise later to sell off a portion of the reserves so as to
mitigate these fluctuations and generate revenues to offset the current
cost of the reserves.
None of this changes the fact that we must always think in terms of
reducing the cost of financing the reserves. Larger reserves provide for
the possibility of placing a portion in riskier investments that could
generate larger returns, as many central banks in a similar position have
done in recent years. It is also possible that, in addition to the distribution
of the costs and benefits of the reserves, which is built into the current
regulatory framework for the financial interactions between the Treasury
and the Central Bank, ways could be found for banks and even other
financial institutions to participate in the cost of financing the reserves,
as these institutions enjoy the benefits of them, including better credit
ratings and lower foreign financing costs. The worst that we could do in
this context would be to sacrifice the long-term benefits of price stability
and economic equilibrium in order to increase the Central Bank's profits
in the short-term.
The monetary policy framework
I would now like to turn to two related topics: the pros and cons of
independent monetary policy, on the one hand, and possible changes to
the monetary policy framework and implementation, on the other. I must
be brief because the clock is ticking, but I am more than willing to
answer questions about this and other points later on.
"Is independent monetary policy too costly?" is the topic of this meeting.
Presumably, the question implied is whether the benefits of such
monetary policy are outweighed by the costs. To my mind, this question
can hardly be answered without reference to the various options
available because we must have some sort of currency regime, and all of
them have pros and cons. If there is a currency union, it is the monetary
policy of the union's central bank that carries the day. In the case of the
eurozone, that is the European Central Bank. The pros and cons of such
cooperation were outlined in detail in a report published by the Central
Bank in autumn 2012, and I do not have time to cover them here.1 If we
continue with our own currency, the question of exchange rate policy
arises: should the króna be pegged against one currency or a basket of
currencies, should it float freely, or should it be somewhere in between?
If the exchange rate is pegged, it is not possible to apply monetary policy
to mitigate economic fluctuations by responding to shocks. The
adjustment will therefore take place more through fluctuations in
employment and output and less through fluctuations in real wages than
is the case with independent monetary policy and a flexible exchange
rate. What do we want in this context? A good stylised example of how
independent monetary policy and a flexible exchange rate could mitigate
the impact of shocks on employment and output can be found in the most
recent issue of Monetary Bulletin, which describes what would happen
if the past few years' improvement in terms of trade should reverse with
a reduction in marine product prices.2
There are many things to consider in this respect. Experience shows that
in small, open economies with unrestricted capital flows and a
freefloating currency, the exchange rate has a tendency to fluctuate
excessively and irregularly, with possible negative implications for
financial stability. And as is discussed in the aforementioned Central
Bank report, such exchange rate volatility can sometimes be a source of
economic volatility. Furthermore, as examples have shown, lack of
fiscal discipline together with overly loose financial regulation and lax
supervision can undermine independent monetary policy with either a
floating or a fixed exchange rate, even if the latter takes the form of a
currency board.
The "capital flow problem", as we could call it, lies in capital inflow
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surges based on excessive optimism and underpricing of risk capital
inflows that then stop and reverse, with fire and brimstone and severe
repercussions for economic and financial stability. Experience shows
that this problem is not limited to countries with a floating exchange rate
- quite the contrary, in fact. Countries with a pegged exchange rate have
suffered severely from just such a scenario, as have countries within the
euro area. This problem was a key player in the crises in Greece and
Spain, to give two examples. As a consequence, there is no less need for
so-called macroprudential tools in countries with a pegged exchange rate
or countries in a currency union than there is in countries with
independent monetary policy and a floating currency. Some view
foreign exchange reserves as the cost of pursuing independent monetary
policy. This is not entirely correct because any country with its own
currency must hold foreign exchange reserves, and it is easy to
demonstrate that the reserves must be larger under a pegged exchange
rate than under a floating exchange rate.
I could continue to beat the drum on simplifications and magic solutions.
The main thing, though, is that selecting a currency and monetary policy
regime is not as simple as it is sometimes made out to be. And it is not
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merely a question of which policy is best if implemented perfectly
because implementation is never perfect. Mistakes are made, and then it
matters how robust the systems are in the face of such mistakes, and
what scope there is to correct them without overstraining the systems.
2
Monetary Bulletin 2016/4, p. 12-14.
http://www.cb.is/publications/publications/publication/2016/11/16/Monetary-Bulletin-2016-4/
Conclusion
In view of the discussion of monetary policy that has taken place
- -
recently not least during the run-up to the Parliamentary elections I
consider it necessary to engage in continued thoughtful discussion of
what type of monetary policy framework will be most appropriate once
the capital controls have been lifted, as we are not members of a currency
union. Many attempts have been made in this regard, and the Central
Bank has published a range of material on the topic. In my opinion, the
monetary policy that has been developing in Iceland during the
-
aftermath of the crisis a monetary policy framework that is quite unlike
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its pre-crisis counterpart has delivered good results in the recent past
and is a viable candidate for the future. But perhaps it is like Groundhog
Day: with each new beginning, we come closer to the solution. Let us
hope so.
If we play our cards right, the benefits of independent monetary policy
could outweigh the costs. That does not necessarily mean that it is the
best of all possible options. Some type of peg is also a possibility that
could be explored, although it, too, has pros and cons, like all others.
The Swedes raised their policy rate to a high double-digit figure in order
to defend their peg, and at one point the policy rate was raised to 500%.
The British raised their interest rates to 15% for the same reason. In
neither instance was this sufficient, however, because other foundations
were no longer in place. Hong Kong managed to defend its peg during
the Asian crisis but had to raise rates significantly and resort to a range
of unconventional measures, including large-scale intervention in the
equity market.
The main conclusion is that neither a pegged exchange rate nor
independent monetary policy with a flexible exchange rate will generate
the intended results unless several other things are in place: policy
instruments designed to achieve those results must be applied as needed,
other economic policies should be aligned with monetary policy
objectives, and prudential policy regarding the financial sector must
support rather than undermining economic stability.