Ingimundur Friðriksson: The Central Bank of Iceland and monetary policy
Speech by Mr Ingimundur Friðriksson, Governor of the Central Bank of Iceland, at a civic club meeting
in Reykjavík, 12 February 2003.
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In recent years substantial changes have been taking place in central banking in many parts of the
world. The main reason is the gradual acceptance of the view that it is natural to anchor central bank
monetary policy to a single main objective. Simplified objectives were therefore set for central banks
and they were granted greater independence to apply their monetary policy instruments, while more
stringent demands were made regarding transparency of monetary policy and central banking
activities, and accountability to the government and general public. As a rule, simplification of central
bank objectives involved defining a single main objective, i.e. to promote price stability. Central banks
were often also assigned a second objective, namely to promote the security of financial systems, or
financial stability.
Price stability was made the main objective of monetary policy because inflation is above all a
monetary phenomenon. There is little point in setting an objective for monetary policy which it cannot
attain. Applying monetary policy in order to achieve price stability also contributes to economic
stability. This, in turn, provides a basis for the economy to be able to achieve lasting growth and make
the most efficient use of its scarce resources.
The year 2001 was an eventful one in the history of the Central Bank of Iceland. In March that year the
government and the Central Bank issued a joint declaration abandoning the fixed exchange rate policy
and adopting inflation targeting as the mainstay of monetary policy in its place. A target was set for the
Central Bank's monetary policy to keep inflation as close as possible to 21⁄2%, to be attained before the
end of 2003. One consequence was that the exchange rate of the króna was floated. Just under two
months later, parliament unanimously passed a new Central Bank Act which entailed extensive
changes from the earlier legislation. Inflation targeting has established itself in many countries in
recent years and has formed the backbone of monetary policy in countries such as the UK, Sweden,
Norway and New Zealand, with good results.
The new act took account of central bank legislation in other countries and one of its aims is to
consolidate the new inflation targeting policy. The most important change from the legislation it
replaced was to set a single principal objective for the Central Bank, i.e. to contribute towards price
stability. It was granted independence to apply its instruments in order to attain this objective.
Furthermore, the Bank was assigned the task of maintaining Iceland's foreign exchange reserve and
contributing to 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 made concerning
accountability and transparency. For example, the Bank is now obliged to present public explanations
every quarter of its monetary policy and monetary, exchange rate and currency developments, and its
measures in these areas.
As I said earlier, the main objective of Central Bank monetary policy is to keep inflation as close as
possible to 21⁄2%. The Central Bank has only a single instrument for achieving this objective: interest
rates. The crucial interest rate here is that used in the Central Bank's repurchase transactions with
credit institutions, sometimes called the policy interest rate. Such transactions effectively represent the
Bank's liquidity facility for these institutions. The commercial and savings banks then decide their own
rates of interest with reference to the Central Bank's policy rate and short-term interest rates invariably
alter in pace with the Central Bank rate. Other things being equal, changes in the Central Bank interest
rate also affect long-term interest rates, but other factors have an impact as well. Their responses to
the Central Bank's interest rate changes are therefore not always foreseeable and tend to take place
with some lag.
Inflation forecasting plays a crucial role in the Central Bank's current activities. It produces four
forecasts a year and publishes them in its quarterly Monetary Bulletin. The inflation forecast is
projected just over two years into the future, on a quarter-by-quarter basis. As in other countries,
Central Bank interest rate changes take a long while to have an impact on the economy. The inflation
forecast therefore needs to be forward-looking and based on the best available methodologies.
Besides inflation forecasting, 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 developments. If inflation is heading beyond the Bank's target on a longer-term scenario, the
Bank raises its policy interest rate, but cuts it if inflation is heading below the target.
In preparing its inflation forecasts and regular assessments of the economic situation and prospects,
the Central Bank examines a wide range of indicators. These are both statistical data and information
obtained from interviews with representatives of industry, organisations with vested interests, credit
institutions and others. The Bank publishes the bulk of its statistical indicators and data on its website.
Central Bank decisions are made after in-depth examinations of indicators about economic
developments, its assessment of the situation and outlook, the assumptions behind the inflation
forecast and the inflation forecast itself. Under the Central Bank Act, the Bank's Board of Governors
have set internal rules on the preparations of, arguments for and presentation of its monetary policy
decisions. These rules were formally set in the beginning of 2002 and published in the quarterly
Monetary Bulletin.
Having said this, it is tempting to try to assess the success of monetary policy implementation after the
framework was changed and the new Central Bank Act went into effect in spring 2001. There was
already some inflation in spring 2001 and a rapid slide in the exchange rate of the króna until the end
of November 2001 caused inflation to increase substantially, from around 4% when inflation targeting
was adopted to 91⁄2% in the beginning of 2002. Inflation surged following heavy demand pressure in
the economy which was driven by large-scale credit expansion and resulted in an enormous current
account deficit, peaking in 2000 at 10% of GDP. For most of the period of overheating the Central
Bank did not follow a direct inflation target and the backbone of monetary policy was a fixed exchange
rate, with a fluctuation band, i.e. a soft exchange rate peg. Nonetheless, the Central Bank sought to
counter inflationary pressures as soon as 1999 and began raising interest rates, which caused the
króna to strengthen until spring 2000. Expectations changed then, partly under the impact of the wide
current account deficit, and the currency inflow diminished. A downward exchange rate trend then
began.
The Bank raised its policy interest rate in phases until the end of 2000 when it reached 11.4%, where it
remained until spring 2001 when a minor cut was made. The interest rate remained unchanged until
late 2001 when the Bank felt it could discern clear signs that inflation was beginning to come down
again. By then, the exchange rate of the króna had fallen by almost one-third from its highest point in
spring 2000. By then the Central Bank had repeatedly stated that the exchange rate of the króna had
become much weaker than warranted by economic fundamentals.
The impact of the tight monetary stance was increasingly felt as the year 2001 wore on. The sharp
turnaround in the exchange rate at the end of November that year and the agreement between the
Federation of Icelandic Labour and Confederation of Employees in December 2001, postponing an
inflation-triggered review of wage agreements, eased the uncertainty and changed expectations. Both
these events led to a rapid drop in inflation in 2002, and by last November the Central Bank's inflation
target was attained, one year before this was envisaged in the joint declaration by the government and
the Central Bank from March 2001.
When it became clear that inflation was on a significant downward path, the Central Bank gradually
began to lower its interest rates. It also announced that it aimed to cut them in more and smaller steps
rather than fewer and larger ones, not least with the idea of maintaining calm in the forex market.
Since April last year the Central Bank has lowered its interest rates eleven times by a total of
4.8 percentage points, including the cut announced on February 10. The Central Bank's rate for its
repo agreements with credit institutions is now lower than it has ever been since the current
arrangements for such transactions were introduced early in 1998, when it was 7.2%, and in fact is at
its lowest level since 1994. The policy rate is currently 5.3%. The exchange rate of the króna was fairly
stable from last spring and until the winter, then strengthened again towards the end of the year and in
the beginning of this year, to reach its highest point for two years. Undoubtedly the expected
power-intensive industrial project in east Iceland is a contributing factor.
The new monetary policy framework was introduced in a fairly tough climate of a sliding exchange rate
and mounting inflation. It is fair to say that the tight monetary stance is the main reason that inflation
went back down so quickly. Experience has shown that the monetary policy passed its initial test with
flying colours and no one should have any doubts now about the value of monetary policy in the
Icelandic economy. It works in Iceland, just as it does everywhere else.
On February 10 the Central Bank published its quarterly Monetary Bulletin. As usual, this contains a
new inflation forecast along with the Bank's latest national economic forecast and a new assessment
of economic and monetary developments and prospects. The bulletin also contains an evaluation of
the impact of the proposed power-intensive industry and hydropower development projects in east
Iceland, which were incorporated into the inflation forecast and national economic forecast.
The forecast assumes that inflation will be below the Bank's target over the next two years. On the
basis of this and the new economic forecast, the Governors announced a cut of 0.5 percentage points
in the Bank's policy rate last Monday. One of the standard assumptions behind the forecast is an
unchanged exchange rate from the forecasting day, and it should be borne in mind that it did not take
into account the interest rate cut which was announced on February 10. The impact of the cut will be a
marginally higher rate of inflation than was assumed in the forecast.
It should also be mentioned that Monetary Bulletin contains an announcement about pending changes
to rules on required reserves aimed at harmonising the operating conditions of Icelandic credit
institutions with those of comparable institutions in EMU. To be implemented in phases this year, the
new rules involve a considerable reduction in the credit institutions' required reserve from the present
levels, thus entailing some easing of the monetary stance.
Broadly speaking, the Central Bank's assessment and forecasts entail a fairly moderate rate of
economic growth this year, unemployment of around 31⁄2% this year (excluding the effects of new
government measures in this area) but falling somewhat next year, a minor current account deficit this
year and next year - in particular caused by imports connected with the construction programmes in
east Iceland - and a very moderate rate of inflation. Thus it can be said that the outlook is for good
macroeconomic balance.
As I mentioned earlier, Monetary Bulletin includes an in-depth assessment by the Bank of the
proposed power-intensive industrial projects in east Iceland and conceivable economic policy
responses to them. In this context it is important to remember that relatively little development will take
place in east Iceland this year and for most of next year. The effect will not begin to be felt to any
extent until well into next year and the bulk of construction work will take place in 2005 and 2006. The
main conclusion of the Bank's analysis is that even though this will be the largest construction
programme in the history of Iceland, it should be able to go through without disrupting the economy.
However, this calls for cautious economic policy implementation. The Central Bank's analysis shows
that with a somewhat stronger exchange rate and higher interest rates than would otherwise have
prevailed, and a tighter fiscal stance than would have been needed, inflation will remain inside the
tolerance limits of the target, i.e. below 4%, and that this will prevent the economic instability that the
construction programme in east Iceland would otherwise have caused. Exchange rate developments
and the fiscal input will be major factors in determining how much interest rates will need to rise.
However, neither an exchange rate adjustment nor fiscal measures can entirely replace monetary
measures, since the change in exchange rate partly reflects expectations of a rise in Central Bank
interest rates, beside which the scope of the east Iceland construction programme will simply be too
great to be countered solely by cutting back public sector activity.
Without sensible economic policy implementation, however, the construction programme would be
likely to lead to overheating of the economy, high inflation and instability. There is no the scope to
discuss the Bank's analysis further here, however, so I shall merely refer to the coverage in the latest
Monetary Bulletin.
In recent public discussions it has repeatedly been claimed that the exchange rate of the króna is too
high and the Central Bank needs to take measures to bring it back down, such as a large-scale cut in
interest rates, which are said to be much higher in Iceland than elsewhere. The fact of the matter is
that the interest rate differential between Iceland and its main trading partner countries has narrowed
significantly recently. The short-term interest rate differential has not been less since 1996. The
Central Bank of Iceland's policy rate is now lower than, for example, those of the Norwegian Central
Bank and the New Zealand Reserve Bank, both of which also apply inflation targeting. The same
applies to the policy rate in real terms, calculated relative to these banks' respective inflation targets.
In fact, in real terms the Central Bank of Iceland's policy rate is at its lowest point since 1996.
In this context it is also important to point out that after the change in the monetary framework in
March 2001, i.e. after an inflation target was set for monetary policy and the króna was floated, the
Central Bank has no specific objective as regards defending the exchange rate of the króna, which is
determined on a day-to-day basis by supply and demand in the domestic forex market. Various factors
affect currency flows, such as interest rates and the interest rate differential with abroad, the
merchandise and services balance and, last but not least, expectations about the future.
It may also be noted that, since the autumn, the Central Bank has regularly purchased foreign
currency in the domestic interbank market. The purpose of such purchases is to boost the Bank's
foreign reserve, which was significantly depleted during its efforts to control the slide in the króna in
2000 and 2001, and not to influence the exchange rate, although undoubtedly they do so to some
extent. The Bank's experience shows that direct intervention in the forex market with the aim of
influencing the exchange rate of the króna only has a short-term effect at best. Regular foreign
exchange purchases were stepped up in January and again in February. Now, the Bank purchases
11⁄2 million US dollars daily and has purchased the equivalent of 11 b.kr. since the autumn.
In the Central Bank's view, various factors may have caused the króna to strengthen in recent weeks,
not least expectations about the east Iceland construction projects, a possible underestimation of the
degree of slack in the economy at the moment, and increased fishing quotas. In assessing the
exchange rate it is important to point out that in real terms the exchange rate is not much higher at
present than its average over the past ten years. Thus there is no possible way to claim that the
current exchange rate is blatantly out of step with what is appropriate for the economy or is far from
the real equilibrium exchange rate.
It has also been claimed that there is a significant risk of deflation in Iceland. The Central Bank
considers the likelihood of this to be negligible. In fact, the talk of deflation can largely be expected to
reflect international discussion of the same issue, with claims from various quarters that there is a risk
of deflation in Germany and the USA in the same way that has happened in Japan. Nothing suggests
that deflation is looming in Iceland - wage costs have risen, growth in money supply is robust, inflation
expectations in the market are around 2% or above, and one of the largest construction programmes
in Icelandic history is on the horizon. It may be added that, up until now, Iceland has never had any
problems in kindling inflation.
In light of all the above, the Central Bank does not believe that there are grounds for a large cut in
interest rates in order to bring down the exchange rate of the króna or dispel the risk of deflation,
which is virtually nil anyway. Such action would probably pave the way for subsequent overheating of
the economy and inflation. The Central Bank will continue to base its interest rate decisions on its
mandatory role of contributing towards price stability and on the joint declaration of the government
and the Bank from March 2001 which specifies the inflation target. Through steadfast monetary policy
which ensures price stability, monetary measures will contribute towards promoting a stable economic
environment which is the foundation for the economy's growth capacity in the long run.
On the basis of the new inflation forecast and national economic forecast, the Central Bank
announced a cut of 0.5 percentage points in the policy interest rate on February 10. The Consumer
Price Index for the beginning of February was published this morning and the change in it turned out
to be fully consistent with the Bank's latest inflation forecast. Developments in the next few weeks and
the prospects ahead will determine the next step as regards interest rates. Opposing trends are at
work there and at present it is impossible to state in which direction or when the next step will be
taken. It also needs to be underlined that if the current outlook turns out to be correct, the proposed
construction programme in east Iceland will gradually begin to influence the formulation of monetary
policy. To conclude, I would like to reiterate that monetary decisions by the Governors of the Central
Bank of Iceland are made after extremely careful consideration of a large number of indicators.