Monetary policy: achievements and challenges
Már Guðmundsson, Governor of the Central Bank of Iceland.
Monetary policy meeting of the Iceland Chamber of Commerce,
held at Gamla Bíó in Reykjavík on 16 November 2017
Madame Chairman, honoured guests,
Once again, we gather here at the Iceland Chamber of Commerce's monetary
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.
In my speech at this same meeting last year, I noted that the Icelandic economy
had seldom been stronger, as we were experiencing the combined effects of
robust GDP growth, full employment, large rises in real wages, below-target
inflation, a current account surplus, a strong international investment position,
and lower private sector debt than had been seen in years. At that time, we had
also achieved a historical milestone in bringing inflation expectations back to
target by most measures. The outlook was positive as well, with the prospect of
continued strong GDP growth, a current account surplus, and target-level
inflation throughout the forecast horizon.
But there were concerns, too: the potential for overheating, the possible
overvaluation of the króna, and the uncertainty about what would happen after the
general liberalisation of the capital controls.
Now, one year later, the economy is still very strong, yet some important
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changes have taken place changes that in some respects have reduced the
potential risks to price stability and financial stability.
First of all, the vast majority of the capital controls have been lifted, and these
risks have not materialised. Short-term exchange rate volatility did indeed
increase, but this was expected, and it was not pronounced enough to cause
financial instability, as I will discuss further in a moment. And exchange rate
volatility has subsided this autumn.
Second, the historical achievement of monetary policy, which was on the
horizon last year, has now been confirmed much more convincingly. The
credibility of monetary policy has increased, as can be seen perhaps most
clearly in inflation expectations, which are now much more firmly anchored to
the target. It is not least this that made it possible to lower the Bank's key
interest rate by a full percentage point in this one year, even though demand
pressures in the economy were growing until recently and interest rates were
already low in historical context in 2016, after adjusting for the business cycle
position. I explained this in detail in my speech last year.
Third, GDP growth appears to be approaching its long-term trend rate more
rapidly than previously anticipated, and indications that the positive output gap
has already peaked have grown stronger. As a result, the likelihood of
overheating has receded, although economic policy mistakes and decisions
made in the labour market could certainly increase that likelihood once again.
As was the case in 2016, the economic outlook is positive, according to the
Central Bank's baseline forecast, published yesterday. GDP growth will slow
over the next three years, but this is both desirable and inevitable. The current
account surplus will be smaller than previous forecast, but a surplus will
remain. There will be full employment, an real wages will rise more over the
entire period than can be expected in the long run. Inflation will converge with
the target in mid-2018 and remain close to target for the rest of the forecast
horizon. This is one of the best inflation forecasts I have seen in my entire
career. But it is a baseline forecast, and unforeseen external shocks, economic
policy, and decisions made in the labour market could easily change the
situation significantly.
Current situation and outlook
Let us now take a closer look at several aspects of the current economic
situation and outlook.
Chart 1 shows how export growth has slowed this year from its 2016 peak yet
remains robust. The combination of weaker export growth and increased
imports explains the year-on-year slowdown in GDP growth. It also explains
the narrower current account surplus, although a deterioration in terms of trade
is also a factor. The current account surplus is projected at 2% of GDP by the
end of the forecast horizon and could easily be eroded by a surge in demand
and/or lower export revenues.
Chart 1
As Chart 2 shows, both private consumption growth and rising house prices are
due mainly to increased real incomes and households' improved financial
position. This differs greatly from the situation in pre-crisis Iceland, where
increased household leverage played a leading role, but as can be seen in the
chart on the right, lending to households has not increased in real terms since
2012.
Chart 2
The fact that inflation has been low in recent years despite steep rises in wages
and house prices stems primarily from two things: on the one hand, positive
supply shocks in the form of strong export growth and improved terms of trade,
which have pushed the exchange rate of the króna upwards, and on the other
hand, price deflation in international goods trade. Import prices have therefore
fallen steeply in krónur terms, as can be seen at the left in Chart 3. What would
happen when this imported deflation turned around was always a source of
concern. Such a development now appears to be on the horizon, as can be seen
in the chart. But fortunately, the rise in unit labour costs seems to be losing
pace, as can be seen in the chart at the centre, and house prices appear to have
peaked. The inflation outlook is therefore favourable, as can be seen in the
chart at the right, which looks past the changes in value-added tax that could
possibly be implemented in the near future.
Chart 3
"Missing" inflation
Headline inflation has been below the Central Bank's target for nearly four
years, even though the negative output gap closed and then turned positive
some time ago and wages have risen well in excess of what, in an average year,
would be deemed consistent with the inflation target.
This is not a unique case, however. In international circles, there is widespread
discussion of "missing" inflation, which generally refers to the fact that wage
rises are astoundingly small given the business cycle position in the country
concerned. For example, countries as dissimilar as the US and Sweden are
considered to be at full employment, yet wage increases are smaller than is
consistent with the inflation target. In some countries, such as the US, this may
be partly because the slack in the labour market is actually larger than
conventional measurements indicate, as the labour participation rate is
historically rather low. But this does not tell the whole tale, and in some
countries it is not a very robust explanation. Given how widespread this
phenomenon is, and given that it is in some respects independent of domestic
conditions and economic policy, there are a number of indications that global
factors such as increased cross-border mobility of labour and other production
factors, international value chains, and the existence of a large excess labour
force in some emerging market economies play an important role in it.
An underestimated slack in the labour market is hardly a factor in Iceland, as
the labour participation rate is at a historical high and wage rises are
substantial. Labour importation and indirect pressures from an unutilised
lower-income labour force in other countries have clearly had a dampening
effect on wage increases, however. Even so, inflation is low. This is true of
other economies as well. But it is less of a puzzle than wage developments in
industrialised countries overall: global trends have been favourable to them, as
can be seen in improved terms of trade and rising exchange rates. It is well
known that this can create conditions where strong GDP growth and sizeable
pay rises can coincide for a time with low inflation. And one difference
between Iceland and many other industrialised economies is that in other
countries there have been concerns that inflation expectations would fall too
steeply and become anchored below target.
In order to place Iceland in this context, let us look at Chart 4, which gives
some relevant metrics for several small and medium-sized inflation-targeting
countries.
Chart 4
In this context, some of the discussion has centred on the extent to which low
inflation is a problem if it is paired with robust GDP growth and full capacity
utilisation, particularly if these are a result of positive supply shocks. In that
case, perhaps the problem lies in how the inflation target is presented and
understood. This will call for more flexibility and a longer horizon for the
target, which was one of the proposals explored in the Central Bank's 2010
report on monetary policy in post-capital controls Iceland.1
Monetary policy milestones
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I mentioned earlier the success we have had with monetary policy success
that was visible a year ago and is even more obvious now. This past
September, the Central Bank of Iceland issued a Special Publication entitled
Monetary policy based on inflation targeting: experience since 2001 and
postcrisis changes.2 In addition to discussing the topics in the title, the report maps
out this success with monetary policy. Chart 5 shows what that entails:
inflation expectations are at target, unexpected changes in inflation that
strongly affected short- and long-term inflation expectations in the past no
longer do so, and movements in the exchange rate of the króna function much
more as shock absorbers and less as sources of shocks than they used to. In
short, monetary policy with a flexible exchange rate is much more successful
now than it had been before 2012, when the Bank published its report entitled
Iceland's currency and
exchange rate policy options.3
Chart 5
Capital flow management tool
There have been proposals in the media recently to the effect that the special
reserve requirement on foreign capital inflows for investment in the bond
market and in high-yielding deposits be immediately reduced or even
Monetary Bulletin,
eliminated. In a Box in the newly published the Bank
discusses this special reserve requirement. It does not agree with these
proposals.
The special reserve requirement has functioned as intended, and monetary
policy transmission along the interest rate channel has improved, as can be
seen at the right in Chart 6. Without it, monetary policy transmission would
have been shifted in greater measure to the exchange rate channel, leading to a
stronger appreciation and increased exchange rate volatility, which would not
have been terribly popular under current conditions. Although the goal is to lift
the special reserve requirement, conditions do not warrant it as yet. It will
probably be necessary to scale it back in increments as demand pressures in the
domestic economy recede and growth in trading partner countries gathers more
momentum. Current forecasts indicate that this will happen, as can be seen at
the right in the chart. Long-term interest rates will reflect this, and the
longterm interest rate differential will narrow.
Chart 6
Another important factor is that it is unclear what benefit the investments
affected by the capital flow management measure have for Iceland at present.
The Treasury's borrowing need is limited in historical context, and strictly
speaking, the Treasury does not need the funds generated by the bonds in
question. If the special reserve requirement were not in effect, the Central Bank
would probably have to hold larger foreign exchange reserves so as to mitigate
the risk associated with carry trade-related inflows and the potential for sudden
outflows. This would be quite costly, as the global market returns on the
reserves are unusually low at present. At the same time, foreign investors can
expect attractive returns on Icelandic Treasury bonds, and the more stable the
króna, the greater the risk-adjusted interest rate differential. In order to reduce
that differential, the Central Bank would therefore need to allow increased
exchange rate fluctuations, which would also exacerbate the risk faced by
residents. Under current conditions, it can even be argued that for the Icelandic
economy, the net benefit from such inflows is negative.
Nevertheless, the aim is to lift the special reserve requirement as soon as
conditions warrant it and that it will not, as a general rule, be used under
normal conditions. Even so, the Central Bank has considered it important to be
able to activate it if the need arises. The special reserve requirement would then
be a third line of defence, to support conventional economic policy and micro-
and macroprudential tools.
In order for this to be possible after the capital controls have been lifted in full,
a new statutory foundation (other than the Foreign Exchange Act) must be
found for the special reserve requirement, which is primarily a monetary and
macroprudential policy instrument. Furthermore, the efficacy of the special
reserve requirement must be ensured once speculative derivatives trading in
krónur has been re-authorised, as full liberalisation implies. The Central Bank
is currently reviewing the technical foundations for the special reserve
requirement and preparing proposals for statutory amendments pertaining to its
application.
Exchange rate fluctuations
The new issue of Monetary Bulletin contains a Box on fluctuations in the
exchange rate of the króna in international context. That article presents several
points that should be borne in mind in any discussion of monetary policy and
possible modifications to the monetary policy framework, including exchange
rate policy. They are as follows:
 Short-term exchange rate volatility increased just after the capital controls
were lifted, as had been expected and as the Monetary Policy Committee
had pointed out in advance in its statements. This volatility has subsided in
recent months (see the right side of Chart 7).

If we look beyond the aftermath of the pegged exchange rate regime, the
financial crisis, and the capital controls regime, it cannot be seen that the
short-term fluctuations of the Icelandic króna have been vastly larger than
other Nordic krónur that have flexible exchange rates, or
commodityexporters' currencies. These currencies also have periods of peak volatility.

Long real exchange rate cycles are a well-known phenomenon, also in
countries with a fixed nominal exchange rate (Chart 8).

As has previously been noted, exchange rate movements have been more
effective as shock absorbers in recent years than they were previously.
Although more effective and more credible monetary policy plays a part in
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this, what is probably more important is that the capital controls and now,
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the capital flow management measure have mitigated volatile capital
flows, which can undermine economic stability, as experience has shown.
Chart 7
Chart 8
Review of the monetary policy framework and currency and exchange
rate policy options
In closing, I would like to focus on the ongoing review of Iceland's monetary
policy framework and currency and exchange rate policy options.
In the recent past, I have emphasised how important it is that this discussion
should take into account what monetary policy can and cannot do. In the long
run, monetary policy can deliver price stability, and in the short run it can also
mitigate the effects of shocks and reduce fluctuations in output and
employment. But monetary policy cannot have a long-term impact on the real
exchange rate. As such, it can do little to mitigate the crowding-out effect of
strong growth in a new export sector. If it tried to, the effect would be only
temporary, and it would come at the expense of sacrificing the objectives with
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which monetary policy has been entrusted objectives that it can achieve.
Industrial and fiscal policies can have such a real impact over the long term,
however, and it is to them that concerned parties should turn.
But it is possible to choose from among various options on the spectrum
between a rigid peg and a free-floating exchange rate. And it is possible to
adopt another currency, either unilaterally or in bilateral or multilateral
cooperation.
These were the options explored in the Central Bank's 2012 report.4
The
conclusion was that a unilateral peg with unrestricted capital flows could run
aground, as it did in so many economies after capital movements were
liberalised further in the 1980s and 1990s. A firmer peg such as a currency
board could pose risks to financial stability, and the same was considered true
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of unilateral adoption of another currency. It was deemed highly uncertain
and actually unlikely - that bilateral adoption of another currency would be on
offer anywhere.
That left two possibilities: joining the eurozone after a negotiated agreement
and continuing with a flexible exchange rate and an inflation target. The
problem was that there were drawbacks to both. The financial crisis had
uncovered flaws in the design of the eurozone, and it also came to light that
political support for eurozone membership was lacking. Independent monetary
policy and a flexible exchange rate had not been very successful.
Has something changed? The euro area is still putting in place the reforms
deemed necessary for it to function smoothly, and it does not seem to me that
political support for membership has increased significantly since the Bank's
report was issued. But various reforms have been made to monetary policy
conduct in Iceland, and financial stability policy has been vastly improved.
Much of what I have called inflation targeting plus has already been put in
place. And in the past few years, we have seen that independent monetary
policy can work effectively, also in Iceland. This is where we are now. That
need not mean that we will be here for the indefinite future. There is no eternal
monetary solution, and various options develop over time.
4
See reference in Footnote 3.