Ingimundur Friðriksson: Monetary policy and the current monetary situation
Address by Mr Ingimundur Friðriksson, Governor of the Central Bank of Iceland, to a civic club
meeting in Reykjavík, 26 February 2003.
* * *
The framework for monetary policy in Iceland was altered decisively in March 2001. The government
and the Central Bank issued a joint declaration adopting inflation targeting as the mainstay of
monetary policy and abandoning the fixed exchange rate policy which had been followed for just over
a decade. To begin with, a relatively narrow target band was set in the previous regime for the
reference exchange rate of 21⁄4% in either direction around the central value for the króna. This was
widened in two stages, to end up as a 9% deviation in either direction early in 2000. During this period,
price stability was the principal objective of monetary policy and a stable exchange rate was an
intermediate target. Since the adoption of inflation targeting, the Central Bank's inflation forecast could
be said to have actually served as an intermediate target of monetary policy, with the ultimate
objective price stability. Inflation targeting has established itself in many countries in recent years and
has formed the backbone of monetary policy, for instance, in the UK, Sweden, Norway and New
Zealand, with good results in each case.
In May of 2001 the Icelandic parliament Althingi unanimously adopted a new Central Bank Act, which
entailed extensive changes from the previous legislation. Taking into consideration innovations in
central bank legislation in other countries, this Act consolidated the new inflation targeting policy. The
most significant change from the earlier legislation was to set a single, principal objective for the
Central Bank, i.e. to promote price stability. The Bank was also granted the independence to apply its
instruments in order to achieve this objective. Furthermore, it was assigned the task of maintaining
Iceland's foreign exchange reserve and fostering an efficient and reliable financial system, i.e. financial
stability. The Act also stipulated that the treasury may not borrow from the Central Bank. Specific
requirements were set out concerning transparency and accountability towards both the government
and the public. For example, the Bank is now obliged to publicly account for its monetary policy and for
monetary and exchange rate developments and its actions in these areas at least quarterly.
The principal objective of current Central Bank monetary policy, as stated in the joint declaration
issued by the Bank and the government in March 2001, is to keep inflation as close as possible to
21⁄2%. Should inflation deviate from this target by more than 11⁄2 percentage points in either direction,
the Bank is to provide the government with a written public account explaining what has caused this
deviation, how the Bank intends to respond and how long it expects that it will take for inflation to once
again return to within the targeted inflation limits.
The Central Bank has only one instrument at its disposal to achieve this objective: interest rates. The
significant interest rate here is that used in the Bank's repurchase transactions with credit institutions,
sometimes referred to as the Central Bank's policy interest rate. Such transactions in fact represent
the Bank's liquidity facility for these institutions. The commercial and savings banks subsequently set
their own rates of interest, having regard to the Central Bank's policy rate, and short-term market
interest rates generally change in phase with the Central Bank rate. If other factors remain constant,
changes in the Central Bank interest rate also affect long-term interest rates, but here other aspects
also enter the picture. The response of these rates to changes in the Central Bank rate is therefore not
always predictable and tends to occur with a certain time lag.
Inflation forecasting plays a crucial role in Central Bank policy. It produces four forecasts annually,
which are published in its quarterly Monetary Bulletin. The inflation forecast extends just over two
years into the future, on a quarter-by-quarter basis. As in other countries, interest rate changes by the
Central Bank take quite some time to have an impact throughout the economy. This makes it
necessary to have a forward-looking policy, with the inflation forecast based on state-of-the-art
methodologies. In addition to its inflation forecast, the Central Bank publishes a quarterly assessment
of the economic and monetary situation and prospects, including a national economic forecast, and
their probable impact on price level developments. If inflation looks likely to exceed the Bank's target
limits in a long-term perspective, the Bank will raise its policy interest rate, or cut this rate if inflation is
heading below the target limit.
In preparing its inflation forecasts and regular assessment of the economic situation and outlook, the
Central Bank examines a wide variety of indicators. These include both statistical data and information
obtained from interviews with representatives of industry, special interest groups, credit institutions
and others. Much of this statistical data is available on the Bank's website.
Decisions by the Central Bank's Board of Governors are made following in-depth examination of these
indicators, based on the Bank's evaluation of the situation and prospects, the premises behind the
inflation forecast and the inflation forecast itself. In accordance with the provisions of the Act which
entered into force in the spring of 2001, the Board adopted internal rules on the preparation of,
arguments for and presentation of its monetary policy decisions. The rules were formally approved at
the beginning of 2002 and published in the quarterly Monetary Bulletin.
The inflation target adopted in March 2001 removed the earlier fluctuation bands set for the ISK
exchange rate and the exchange rate was floated. The new monetary policy framework was
introduced under rather difficult conditions, with a sliding exchange rate and mounting inflation. It is fair
to say that the tight monetary stance is the main reason that inflation receded as sharply as it did in
2002. Experience has shown that the monetary policy passed this demanding trial with flying colours
and no one should any longer doubt its value for the Icelandic economy. It works in Iceland just as it
does everywhere else.
The Central Bank responded to imminent inflationary pressure by raising its interest rates in 1998 and
still further in 1999 and 2000. The interest rate increase served to reduce excess demand in the
economy and the ISK exchange rate rose, thus slowing increases to the consumer price index (CPI) in
an overheated economy. Early in 2000 the fluctuation bands for the króna were widened, in part
because the previous limits were then felt to be restraining the rising exchange rate, which was
regarded as necessary to counter inflationary pressure. The exchange rate peaked in the spring of
2000, when it was just over 12% higher than at present.
Market expectations changed in the spring of 2000, and the exchange rate began a downward trend.
There are no doubt various explanations as to why this occurred but probably the major factors were
concern at a sizeable current account deficit and the resulting enormous need for foreign financing,
together with Icelandic investments in foreign securities during that same year, not least by pension
funds. The downward exchange rate slide lasted until late November 2001.
Several times during the period from mid-2000 until well into 2001, the Central Bank intervened in the
currency market in an attempt to prevent a further decrease in the exchange rate. The Bank
intervened in particular when a downward spiral seemed to be forming, or when the Bank felt that its
intervention could have a positive effect in changing market expectations. This was based in part on
the Bank's conclusion that the exchange rate had already dropped more than was reconcilable with
long-term equilibrium in the economy. The Central Bank expended substantial sums in intervening on
the foreign exchange market, over ISK 40 billion in total, without this sufficing to halt the slide of the
króna. At best, it may have slowed the depreciation until the economy had cooled somewhat, and it
also contributed to making the inflationary impact of the exchange rate drop less than it would
otherwise have been.
An article by Gerður Ísberg and Þórarinn G. Pétursson in this February's issue of the Central Bank's
Monetary Bulletin describes the Bank's actions on the foreign exchange market during 2000 and 2001
and assesses their impact. The article concludes definitively that at best the intervention had only
short-term effect in each case and the market soon returned to its previous situation. In other words,
their conclusion is that intervention on the foreign exchange market against strong prevailing currents
has precious little effect unless accompanied by corresponding changes in the domestic interest rates.
This is in full accord with the experience in other countries.
In recent public discussion the claim has often been made that the exchange rate of the króna is far
too high and that the Central Bank needs to take steps to bring it down again. The fact of the matter is
that the Bank's means of controlling the exchange rate are overestimated and the power of the market
underestimated when the claim is made that the Central Bank can, through its actions, direct the króna
to a specific level. The proposal has been made, for instance, that the Central Bank cut its interest
rates substantially with the aim of lowering the exchange rate. In this context it should be pointed out
that the Bank has cut its policy rate substantially, from 10.4% only a year ago (11.4% two years ago)
to 5.3% at present. The Bank's nominal policy rate has not been lower since 1994 and the real policy
rate is at its lowest since 1996. The domestic and foreign interest rate differential has narrowed
significantly. In addition, the Central Bank's interest rate is now below the estimated equilibrium
interest rate and thus has a stimulating effect on the economy. The impact of interest rate changes
generally is only visible after a certain time lag, prompting one to conclude that the effect of the major
decrease in interest rates during the past year has yet to be fully felt.
As is well known, the exchange rate for the króna plummeted in 2000 and 2001, and for quite some
time was substantially below a level reconcilable with long-term equilibrium. This occurred at a time
when the price of key exports was very high, making the years 2000 and 2001 especially favourable
for the export sector and in fact also for import competing sectors. Enterprises in these sectors now
understandably feel the effects of the rise in the exchange rate. It is not to be expected, however, that
the same conditions will again arise in these sectors as prevailed, for example, during 2001 and in the
early part of 2002. In this connection it could be mentioned that, based on the predictions on
performance made by financial enterprises, the contribution margin in fisheries companies will be fairly
good this year, although not as good as in 2001 and 2002, which were quite exceptional.
In the February issue of its Monetary Bulletin, the Central Bank published an analysis of the proposed
major construction projects in East Iceland1 and possible responses for economic management. The
article concludes that unless economic counter-measures are taken, the projects will create
overheating in the economy, inflation and instability. Although their scope will be considerable, the
projects are not so large that economic stability cannot be preserved and inflation contained by means
of appropriate responses in economic management. Mitigating measures would be most effective if
they involved both monetary and fiscal restraint, as well as internal adjustment of the national
economy, including a rise in the exchange rate. The more restraint shown on the fiscal side, the less
need there will be to raise interest rates. A higher króna exchange rate also means less cause to raise
interest rates.
The exchange rate was fairly stable from the spring of 2002 until early this winter. It then began to rise
and continued to do so steadily until early February of this year. The Central Bank has stated its view
that the exchange rate rise in recent months has been primarily due to the effect of the proposed
major construction projects in East Iceland. The operations of the aluminium smelter will likely cause
the equilibrium exchange rate for the króna to be higher than otherwise. Furthermore, it appears
evident that the influx of foreign currency in connection with these projects will be considerable, with
higher domestic interest rates than otherwise. All of this affects market expectations and makes the
króna exchange rate higher than it would be in the absence of plans for major development in East
Iceland. The economy could thus be said to have already begun adaptation to the coming projects, i.e.
the exchange rate adjustment has begun and is even well on its way.
In view of what has already been said, it is clear that industry and business in Iceland has to prepare
itself for a higher exchange rate than would have been the case without this major development. It
naturally demands careful management and cost-cutting in operations where required.
As mentioned previously, the Central Bank of Iceland now practices inflation targeting intended to
keep inflation as close as possible to 21⁄2% per year. The Bank's latest forecast predicts that inflation
will be slightly below this mark during the next two years, or just over 2%. Following this forecast, the
Bank cut its policy rate by 0.5 percentage points.. All other things being equal, this will mean that
inflation will be slightly higher than that assumed in the forecast. Were interest rates to be lowered
significantly from the current level, it would very likely set off a new wave of inflation and instability,
which would be to the advantage of neither wage earners nor industry.
As mentioned, there seems to be some overestimation of the possibility of the Central Bank to control
the market rate of exchange. But, as was also pointed out, the Bank's intervention on the foreign
exchange market, expending large sums in 2000 and 2001, had only a short-lived effect. In this
connection, it should also be noted that since last autumn the Central Bank has regularly purchased
foreign currency in the domestic interbank market. When this decision was announced, it was stated
that the Bank intended to purchase the equivalent of ISK 20 billion of currency by the end of 2003. To
start with the Bank purchased USD 1.5 million on Mondays and Wednesdays each week. This
January the Bank also began to purchase this same amount on Fridays as well, and in February
purchases were added on Tuesdays and Thursdays. Currently the Bank thus purchases
USD 7.5 million each week, or the equivalent of USD 390 million on a yearly basis. Even though the
impact of these purchases on the exchange rate will likely be slight in the long term, as is generally the
case with such intervention on the foreign exchange market, the króna rate will be somewhat lower for
a while than would have otherwise been the case.
1
Aluminium smelter and related power plants.
As was previously pointed out, the Central Bank spent the equivalent of ISK 40 billion to try and shore
up the falling króna in the years 2000 and 2001. As a result, the Bank's net external position worsened
significantly and since that time its currency reserves have to a considerable extent been maintained
with foreign short-term loans. The Bank's plans to purchase the equivalent of ISK 20 billion in foreign
currency, announced last autumn, involved paying off at least a major portion of short-term debt. This
was also the primary purpose of the purchases.
The decision on foreign currency purchasing was taken under completely different conditions than
existed later in the winter when the major development projects in East Iceland changed from plans to
reality. The Central Bank's foreign currency reserves are currently ISK 36 billion (USD 460 million) and
it could be argued that they need to be considerably greater. Considering the new circumstances and
the altered outlook due to the expected major development and resulting influx of foreign currency,
barring unexpected changes the Central Bank will very likely continue its regular purchases of foreign
currency on the domestic interbank market even after reaching the ISK 20 billion point. By so doing
the Bank would avail itself of the opportunity to boost its foreign currency reserves beyond that which
would otherwise be practical.
Public discussion in recent weeks has been characterised by considerable criticism of the Central
Bank and its monetary policy. From the Bank's point of view, the debate seems a bit peculiar in some
respects, not least because views have typically been attributed to it which have no basis in the
writings, speeches or other statements issued by the Bank or its executives. As has been pointed out,
people also seem to overrate the ability of the Central Bank to direct market developments, as well as
to expect it to strive to achieve all sorts of objectives which it has practically no possibility of
accomplishing, and which are in fact not part of its role, such as ensuring a certain exchange rate, full
employment, etc. After the introduction of inflation targeting in 2001, the Central Bank has no specific
objective as far as the exchange rate is concerned. This is in accordance with its policy of targeting
inflation and a floating exchange rate. This has been interpreted to mean that the Bank is completely
disinterested in developments in the exchange rate. This is not true. The exchange rate for the króna
is very important, the events of the past year or two are more than sufficient indication of that. As the
Bank has previously pointed out, the real exchange rate at present is not far from average over the
past 20 years, nor much above the average of the past 10 years. The nominal exchange rate since the
beginning of this year is in fact slightly lower than it was during the same months two years ago. The
exchange rate for the króna is determined by the situation and strength of the national economy,
external equilibrium and market expectations. The present exchange rate thus reflects to a
considerable extent factors which the Central Bank can do little to influence.
The large exchange rate fluctuation from 2000 to 2002 can be attributed to specific circumstances,
and the exchange rate is unlikely to fluctuate as substantially in the immediate future as it did during
this period. It should be borne in mind, however, that the nature of the Icelandic economy and its small
size does mean that currency fluctuations as a rule will be greater than between the currencies of
larger economies. In this connection, however, it can also be pointed out that the Euro lost more than
one-quarter of its value against the US dollar from the beginning of 1999 until it bottomed out, and
since that time has risen once more by just over one-fifth.
The Central Bank is not unconcerned about the exchange rate, but has limited means of influencing its
development, as has been explained. There is only so much the Bank can do to restrain currency
fluctuations. A substantial lowering of interest rates could possibly force the exchange rate down
somewhat, but this would mean sacrificing other and more important objectives for precious little gain.
The joint declaration issued by the government and the Central Bank in March of 2001 states that the
Bank will intervene in developments on the foreign exchange market through buying and selling
foreign currency if it deems this to be necessary in order to achieve its inflation target, or if it is
concerned that exchange rate fluctuations could threaten financial stability. There is no cause for so
doing at present.
As I mentioned, the primary objective of the Central Bank's monetary policy is to foster price stability.
Price stability is recognised to be a prerequisite for long-term economic growth and thus improved
welfare. The Central Bank has lightened its monetary restraint substantially in recent months. In the
course of ten months, the policy rate has been cut very significantly, resulting in a real policy rate
which is lower now than it has been since 1996, as I mentioned. At the same time, the Bank has also
given notice that further relaxation is envisaged in the form of lower required reserves by the Central
Bank. The impact of the recent interest rate cuts has yet to be fully reflected in the economy. Although
claims are frequently advanced that the real exchange rate for the króna is currently too high, the
Central Bank cannot influence the real exchange rate except for a limited time. Too much relaxation of
monetary policy at present would only prepare the ground for the next period of over-expansion and
inflation, with accordant instability.
As mentioned, the Central Bank announced an interest rate cut of 0.5 percentage points earlier this
month and plans to relax reserve requirements. The announcement of the Bank's decision also
pointed out that there were opposing arguments as to whether and to what extent further relaxation of
monetary restraint would be implemented. Following the announcement of the interest rate cut, the
government announced its plans to allocate funding to various construction projects to support
employment, with several local authorities following suit. Furthermore, it now appears likely that work
will get underway this year on an enlargement to the Norðurál aluminium smelter and power
developments linked to it. These factors will naturally be taken into consideration in decisions on
monetary policy in the weeks and months to come.
As I mentioned at the beginning, the framework of monetary policy was changed in 2001 with the
introduction of inflation targeting. This is in line with international developments in recent years,
resulting in Central Banks being entrusted with a single main objective, i.e. to promote price stability.
Price stability was set as the primary objective of monetary policy because inflation is above all a
monetary phenomenon. There is little point in setting objectives for monetary policy which it cannot
achieve. Applying monetary policy to achieve price stability also contributes to economic stability. This,
in turn, is a prerequisite for future growth in the economy and making the most efficient use of its
scarce resources. Other public authorities, industry and interest groups also need to adapt their
decisions to accord with this inflation targeting.