13 April 2023
Monetary and Fiscal Dimensions of
Responding to Multiple Global Shocks
Presentation at the 15th Annual Meeting of the OECD Working Party of
Parliamentary Budget Officials and Independent Fiscal Institutions by Rannveig
Sigurðardóttir, Deputy Governor for Monetary Policy, Central Bank of Iceland
It is a pleasure to join you here to discuss the role and interaction of monetary and
fiscal policy - a topic that deserves our full attention today in times of high inflation.
The global economy had barely recovered from the financial crisis when it was hit
again by two subsequent shocks that have had enormous impact on both
monetary and fiscal conditions around the globe. I want to give you a snapshot of how
the Icelandic economy has weathered these shocks relative to other OECD
economies, firstly, during the COVID-19 pandemic and subsequent supply-chain
disruptions, and then, following Russia's invasion of Ukraine, the ensuing energy and food
crises. Finally, I will discuss the role played by monetary and fiscal policies in
response to these shocks.
Iceland was among the countries most severely hit by the global financial crisis
(GFC). Prior to the crisis, the country was uniquely vulnerable due to
macroeconomic imbalances, including a large current account deficit, unfavourable net
international investment position, highly indebted households and business sector,
inflated asset prices, and an oversized and undercapitalized banking sector.
Iceland's strength, on the other hand, was the relatively strong position of its public
finances. This set Iceland apart from several other countries that also suffered badly
from the GFC, mainly because of vulnerability of public finances. In the aftermath
of the crisis, the economy was rebalanced; the current account transformed from a
deficit to a surplus; the international investment position changed from large net
debt to significant net assets; a major share of private debt was wiped out; the
banking system recapitalized; and asset prices deflated.
The economic consequence of the pandemic
As a result of the rebalancing of the economy following the financial crisis, Iceland's
economy was in a position of relative strength when the pandemic struck. The
macroeconomy remained broadly balanced, despite a negative shock to exports in
2019. Unemployment was low, private sector indebtedness relatively benign,
inflation moderate and public finances had recovered significantly from the turmoil
following the GFC. The human suffering from the pandemic was also less pronounced
than in many advanced economies. Iceland's relatively young population, strong
health care system, low population density and the relatively well-balanced
management of the outbreak, are all likely positive contributing factors.
Icelandic economy at a glance versus OECD countries in 2019
Measures taken to slow the spread of the disease were relatively successful and the
Icelandic authorities did not need to impose exceedingly stringent and protracted
restrictions, as was required in many other countries. As a result, the impact of the
pandemic on households' willingness and opportunity to spend and on corporate
operations was milder than in countries where stricter measures had to be adopted.
Thus, the impact of the pandemic on domestic demand was less pronounced.
Despite relatively successful public health measures, the large share of tourism
services in Iceland's GDP made the economy quite vulnerable to the economic
consequences of global restrictions on travel and tourism services. In 2019 tourism and
tourism-related services amounted to about 8% of Iceland's GDP, a proportion
second only to that of Portugal and Spain in the OECD. Reflecting the weight of
tourism in exports, Iceland's exports contracted by 31%, more than in any other OECD
country, and service exports shrank by 54% in the wake of restrictive measures
taken by all major trading partners. Other tourism-dependent countries such as
Greece, Spain and Portugal also suffered severe export shocks.
The weight of tourism and the effects of COVID on exports
In 2020, economic activity in Iceland contracted by 7.2%, compared to 4.9% on
average in main trading partner countries. The difference may appear smaller than
expected given the size of the shock to exports. As a small open economy, Iceland
imports a large share of consumer durables, investment goods and tourism
services. Therefore, a considerably larger share of shocks to aggregate demand tends
to be absorbed by the external sector than in larger, more self-contained advanced
economies.
Strong imports result in negative trade balance
The smaller than expected effect of the pandemic on Iceland's economy can
therefore be attributed to rather agile expenditure switching, helped by a 12%
depreciation of the króna relative to the trading partner currencies from end-February until
early May 2020. Local consumers and firms transferred their expenditures during
the pandemic from imported consumer durables, investment goods and
tourismrelated services to domestic services and housing. As in other countries, they also
ramped up their savings. Iceland's imports contracted by 21%, more than
elsewhere in the OECD. The contribution of net trade to output growth was still
negative by 5.5 percentage points.
The combination of agile expenditure switching, and fiscal and monetary stimulus,
considerably softened the shock to household finances and corporate profitability.
After a short pause, the housing market recovered, as households took advantage
of record low interest rates. The impact of the pandemic on the economy was
therefore not as strong as expected.
Recovery amidst a war in Europe
The global recovery turned out to be stronger than expected and rekindled
inflation in most parts of the world. In Iceland, the recovery was particularly strong,
driven by a sharp reversal of the contraction in services exports. Like other
countries, Iceland suffered from the inflationary impact of global bottlenecks as the
structure of global demand changed and expanded post-COVID, but a significant
share of the increasing inflation in Iceland can be attributed to excess demand for
housing and faster wage growth than in most other OECD countries.
As in other parts of the world, the recovery has been complicated by the impact of
the Russian war against Ukraine, which in many countries has been simultaneously
inflationary and contractionary - threatening stagflation. In the case of Iceland, the
impact of the war has been mostly inflationary, initially, much less so than in
countries which before the war relied on imported gas from Russia and on fossil fuels
for heating and electricity generation. As electricity generation and heating in
Iceland is based on domestic renewable energy, its economy has not been directly
affected by the spike in gas and electricity prices which most European countries
have suffered greatly from.
The energy crisis mostly bypassed Iceland
Iceland has been spared the most damaging negative consequences of the war in
Ukraine on its economy. Firstly, the share of exports to Russia, Belarus and Ukraine,
the three countries most affected by either the war or sanctions, is relatively small
compared to many European countries. Only 1.7% of Iceland's goods exports went
to these countries in 2020. The weight of imports from these countries in Iceland's
value chain is most likely insignificant and can easily be replaced by imports from
other countries. Because Iceland is a very small economy and price taker in most
export markets, the loss of one market can easily be replaced by shifting to other
markets.
The war in Ukraine has not affected trade directly
Although the war in Ukraine has affected Iceland's terms of trade, the net effect is
ambiguous, with the prices of both imports and exports rising. Iceland is an
exporter of both metals (mainly aluminium) and food products and thus has both
gained and suffered from rising raw material and food prices. Terms of trade have
remained favourable, although they have declined from their recent peak.
Despite access to abundant domestic renewable energy, imported fossil fuels
impact the Icelandic value chain both through the price of imported fuels, various
imported goods and generally the cost of transportation, which is high given
Iceland's remoteness from major markets. Fuel is also an important cost item in
fisheries. Rising import prices, however, result not only from the war in Ukraine, but
can be partly explained by supply-chain disruptions and the container cost crisis
triggered by a reallocation of resources in the global economy as it recovered from
the pandemic. The cost increases seep into the global value chain and affect
inflation globally. Eventually those mismatches are being resolved from the supply side,
as firms respond to price signals, and from the demand side, with global tightening
of monetary conditions and the withdrawal of fiscal stimulus.
Mismatches are being resolved by increased supply and global tightening
The post-pandemic recovery in Iceland has two distinguishing features that set it
apart from the recovery in most other OECD economies. Firstly, the expansion of
the tourism sector and the associated construction boom have relied quite strongly
on imported labour. Because of net migration the average rate of population
growth since 2016 has been 2%, far higher than in other advanced countries. The
rate of population growth has also been quite variable. To some extent, cyclical
expansion has been facilitated by variability in the net migration rate rather than
the domestic unemployment rate. Population growth fell into negative territory
following the GFC, but has twice peaked at 3% during periods of tourism sector
expansion, before and after the pandemic.
Recovery of tourism causes net migration to rise
While the variability of net migration can be a useful shock absorber, helping to
keep unemployment low and relatively stable during downturns and make the
labour market less overheated during expansions, variable population growth
creates problems in the housing market. The most recent surge in net migration has
amplified the impact of COVID-related expenditure switching on housing prices.
The demand for housing fluctuates in line with migration; however, the character-
istically inelastic supply of housing may become even more inflexible if volatile
migration makes future housing demand more uncertain. As a result, what is gained
in terms of a more flexible labour market may be lost due to a more volatile
housing market.
Variable net migration affects the housing market
Iceland's tourism and construction sectors typically attract workers from other EEA
countries during expansions. This time around, there has been an additional push
effect from the war in Ukraine as Iceland has received a significant number of
Ukrainian war refugees. The number of asylum seekers from other parts of the
world has also risen. Many refugees and asylum seekers have already found work,
but finding permanent housing has been a challenge. This may have contributed
somewhat to higher housing prices recently and thus higher inflation in Iceland.
Iceland's strong economy and relatively good employment prospects will likely
continue to attract migrants and asylum seekers even after the war ends. The
strong link between net migration and house price inflation suggests that
policymakers need to pay attention to the role of the housing market in Iceland's inflation
dynamics. There are two roads to a more balanced outcome. Firstly, better demand
management could make the demand for foreign labour and hence immigration
more stable. Secondly, if the supply of housing could be made more elastic,
housing price volatility would diminish. In the face of the large external shocks the
economy has suffered in the past few years, both will be needed, but these are
challenging tasks with no easy solution.
Due to the strong recovery of tourism, the output gap returned to positive territory
at an earlier stage than in most other OECD economies. In addition to the housing
market, emerging overheating has become most visible in the labour market.
The output gap moved to positive territory earlier that in most OECD countries
Wage growth in Iceland averaged above 7% during the pandemic, a somewhat
faster pace than over the preceding decade and much faster than in main trading
partner countries. Recently, short-term wage settlements have been concluded
that imply that the fast pace of wage growth will continue at least for the coming
year.
Wage and ULC growth in Iceland has been much faster than among peers
This is worrisome for medium-term inflation prospects, since the buffers that
existed in the decade prior to the pandemic, and allowed faster wage growth for
several years without commensurate inflationary consequences, have been
depleted. The depressed level of relative unit labour costs following the GFC, fast
expansion of tourism services exports in 2015 - 2017 and a current account surplus
had allowed the króna to appreciate, with moderating impact on inflation. As the
buffers are depleted, the relationship between wage growth and inflation is likely
to be much less benign in the period ahead than during the pre-pandemic period.
The fiscal and monetary dimension of the response to pandemic
and war
Three factors are likely to have determined the fiscal and monetary response of
different countries to the pandemic: i) fiscal and monetary space at the outset, ii)
the severity of the outbreak and iii) structural factors that affected the economic
impact of the outbreak and restrictions imposed to contain it. On the first two
accounts, Iceland was in a relatively good position. Modest public debt gave the
government significant fiscal space, and the outbreak and restrictive measures were
moderate. The structure of the economy, on the other hand, with tourism-related
services being the largest sector, created a large potential demand for fiscal
accommodation to compensate affected firms and households, as discussed above.
As in other countries, both fiscal and monetary policy were applied to respond to
the pandemic with substantial easing, and the size of the fiscal measures taken
were close to the average in OECD countries.
Fiscal measures in response to the pandemic
Iceland's monetary space was also substantial, with domestic interest rates being
significantly above zero at the outset of the pandemic. However, the size of
Iceland's monetary space should not be overestimated. The combination of relatively
illiquid currency markets, fairly strong exchange rate pass-through to prices and a
long history of monetary instability limit how much the interest rate differential
visà-vis abroad can narrow without a risk to inflation. Nevertheless, the Central Bank
of Iceland's policy rate was reduced to a historical low, greatly softening the blow
to the domestic economy, especially the construction sector. As it turned out, the
economy recovered very strongly as COVID restrictions were lifted and the Central
Bank needed to withdraw the monetary stimulus and start raising interest rates
earlier and at a faster pace than most advanced countries.
From accommodative to tightening policy
Reversing the stance of fiscal policy has been a more gradual process. As
temporary support measures have expired, the fiscal stimulus has gradually petered out
and, with the economy expanding faster than previously forecast, public finances
have also recovered faster than expected. The accelerated pace of the economy
provides an opportunity to reach a structurally adjusted fiscal balance at an
earlier stage than expected. However, although the current fiscal policy framework
may be relatively transparent and predictable, it does not seem to provide a
sufficiently strong incentive to take advantage of unexpected fiscal windfalls in a
counter-cyclical fashion. Consequently, monetary policy has been forced to carry
a larger share of the burden of adjustment than would be desirable from the
standpoint of an optimal policy mix.
As inflation hits social groups differently, fiscal policy can be effectively used to
support the most vulnerable groups in the economy. However, as the immediate
impact of inflation on the fiscal balance is positive - as revenues are in practical
terms price-indexed during times of high inflation - it is important that fiscal policy
resist the temptation to allow increased revenues to feed into expenditures more
than is necessary. From the standpoint of the monetary authorities, while providing
support to vulnerable groups, the fiscal authorities could prioritise tightening the
fiscal stance and take advantage of the strong economic growth to close the
budget deficit.
The war in Ukraine still poses significant risks to the global economy. However, as
the global energy and food crisis is resolved and monetary and fiscal stimulus is
withdrawn, the prospects for global disinflation improve. Recent financial market
turmoil may complicate the transmission of monetary policy in some countries. If
it amplifies the downturn in economic activity, it may accelerate disinflation from
what is currently projected, although so far this appears unlikely to fundamentally
change the outcome. Inflation and inflation expectations have started to decline in
Europe and the US. Disinflation may take somewhat longer in the case of Iceland,
given the still strong economic momentum and prospects for higher wage growth
than in trading partner countries. Much will depend on the interaction between
three markets: the labour market, the housing market, and the foreign exchange
market. Monetary policy will have to remain tight until the relationship between
the three markets has been stabilized. Stronger counter-cyclical fiscal policies
would shorten the time needed to reach the balance and bring inflation to target.