Már Guðmundsson: Monetary policy objectives and developments in the
Icelandic economy
Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at a breakfast
meeting of the Iceland Chamber of Commerce, Reykjavik, 6 November 2009.
* * *
In general, monetary policy is conducted under conditions of uncertainty. The future is
always uncertain, of course, but so are the present and the recent past - at least, when one
is assessing the state of the economy. This is axiomatic to anyone who has had to wait for
national accounts figures in order to estimate current GDP growth and has then seen
statistics revised repeatedly over a period of several years. Another source of uncertainty is
the effect of monetary policy instruments on other interest rates, exchange rates, asset
prices, demand, and inflation. Naturally, we know a great deal about the relationships in the
economy, but we don't know what the correct model of it is, and we probably never will, as
economic structures change over time. Furthermore, expectations play a key role in the
entire process, and while they may remain reasonably stable for a time, other periods of time
will come, and expectations will become unhinged. The relationship between interest rates
and exchange rates under conditions of free cross-border movement of capital is different to
the relationship that exists under capital account restrictions. In general, the monetary policy
transmission mechanism depends on the maturity of the financial markets. These
uncertainties and complexities, of course, are the reason for monetary policy committees and
heavily staffed central banks.
If monetary policy is complex under normal circumstances, the complexity is multiplied in a
financial crisis, especially a crisis as deep as the one that Iceland has been going through.
Some of the markets that are important for monetary policy transmission stopped functioning
to a substantial degree. Financial institutions became impaired, and they responded
differently to the Central Bank's monetary policy instruments than they did before the crisis.
The relationship with the rest of the world changed. The link between exchange rates and
interest rates weakened. And expectations became seriously unstuck. Matters were further
complicated because we had to change the rules of the game in response to the crisis; for
example, by imposing capital controls.
It is important to remember this when evaluating monetary policy in Iceland under the current
circumstances. At present, the monetary policy framework is defined by the economic
programme agreed between the Icelandic Government and the International Monetary Fund
(IMF). The other key elements of the programme are the medium-term fiscal sustainability
plan and the financial market restructuring plan.
According to the programme, the most important task of monetary policy is to promote
exchange rate stability. One reason for this is the currency crisis that accompanied the
financial crisis, pushing the exchange rate far below levels previously thought possible, let
alone desirable. This currency collapse fuelled inflation, of course, and amplified the debt
crisis faced by households and businesses. Two factors played leading roles in that
development. The first is the relatively large share of foreign-denominated loans - an
average of 20% for households and 70% for businesses. The latter factor is an unusually
strong exchange rate pass-through effect, which stems from the magnitude of the exchange
rate drop and the lack of confidence that the króna would recover in the near future. As a
result, the principal of indexed loans - which constitute about 70% of household debt and
10% of business debt - was written up. As is often the case in severe financial crises that are
at the same time country crises, there was a genuine risk of a multi-faceted spiral of currency
collapse, inflation, debt crisis, and economic contraction. It was critical to stave off such a
vicious cycle, and therefore of vital importance to stabilise the exchange rate.
But this was problematic because of the large amount of capital that had accumulated in
Iceland through carry trading during the economic upswing. Current estimates indicate that
some 500 b.kr. remain in the Icelandic economy. There was the risk that this money would
try to escape through a collapsed foreign exchange market, with unimaginable
consequences for the exchange rate. Thus it was quite possible that astronomical interest
rates would have been required if exchange rate stability were to be achieved through
interest rate policy alone. In view of this, it was decided to impose broad-based capital
account restrictions and thereby create the scope for less restrictive monetary policy than
would otherwise have been feasible.
As is usually the case, there were probably other options available at the time. But because I
prefer to focus on the current situation and the road ahead, I would prefer not to spend time
rehashing the past and ruminating about hypothetical options. Such speculation cannot
change the past. Generally speaking, however, it seems to me that other options would have
entailed significantly higher interest rates - initially, at least - and more risk to the exchange
rate. But that doesn't change the fact that, although the capital controls provided a certain
temporary shelter, they also entail significant cost and inconvenience, which probably vary
directly with the length of time the controls are in place. That cost will ultimately cut into GDP
growth for the short term and reduce the level of GDP in the longer term. Understandably,
then, we do not wish to maintain the capital controls a minute longer than necessary.
Strictly speaking, monetary policy is not based on an inflation target at present - at least, not
for the short term - as the interim goal of arresting the fall of the króna and then stabilising it
has taken priority. Ultimately, of course, this policy is consistent with the attainment of the
inflation target. It would have been tempting to take somewhat greater short-term risk with
the exchange rate and direct monetary policy more toward domestic economic conditions
and the inflation outlook, but the enormous damage that even a short-lived additional
depreciation would have done to private sector balance sheets precluded such an approach.
Under conventional circumstances, inflation-targeting monetary policy can be described,
albeit in an oversimplified way, as entailing a policy interest rate that takes into account three
factors:
1) the desired policy rate when inflation is at target and GDP is at potential; 2) the output
gap; and 3) the deviation of inflation from target. In the case of Iceland, the exchange rate
must be added to this list, and with a heavy weight. But the weight of the other items is not
zero, and the importance of the exchange rate should diminish as the financial crisis
relinquishes its grip and we reduce the weight of foreign debt in private sector balance
sheets, thereby reducing the impact of the exchange rate on domestic liabilities. One of the
Monetary Policy Committee's many tasks at present is to assess how these various weights
should evolve as circumstances change.
Indicators presented at the most recent Monetary Policy Committee meeting suggest that
foreign-denominated debt may weigh less heavily in corporate sector debt than was
previously believed, and that it is currently diminishing in importance for both households and
businesses. Before the banks collapsed, an average of 70% of corporate sector debt was
denominated in foreign currency. But the distribution is quite skewed. Holding companies
had a large share, and large and medium-sized firms were more likely to have foreign debt
than were small firms. Over half of businesses had domestic-currency debt only. In addition
to this, the weight of households' and businesses' foreign-denominated debt will probably
decline in the near future, both due to debt restructuring and because the vast majority of
new bank loans are in domestic currency. The banks have limited capacity to lend in foreign
currency, both because of a shortage of foreign exchange and because they are operating
under temporary exemptions from Central Bank rules on maximum foreign exchange
imbalances. Of course, this is good news, in a sense, because the sooner the weight of
foreign debt diminishes, the sooner monetary policy will be released from the straitjacket of
restraint far greater than is desirable in light of current domestic economic conditions. Other
factors that could help in this context are new foreign exchange inflows and lower risk premia
on domestic króna-denominated assets, which would obviate the need to maintain exorbitant
interest rates in order to keep ISK assets in the country or attract new capital.
I have expanded at some length on current monetary policy objectives because I consider it
important that these objectives be understood. But what are the instruments of monetary
policy? It can be said that, apart from reserve requirements and other similar tools, which are
seldom changed, the Bank's interest rate decisions, foreign exchange market intervention,
and capital controls are its chief monetary policy instruments. These instruments must be
properly aligned, and consequently, interest rate decisions take account of capital controls.
The controls provided some shelter for interest rate decisions for a while; however, as soon
as they are relaxed, interest rates must be high enough to give investors an incentive to hold
ISK assets. Just how high they must be is determined in part by the risk premium on the
Republic of Iceland, which fortunately has declined significantly in the recent term. For
example, the Republic's CDS spread has fallen from around 1000 basis points at the
beginning of the year to about 350 points.
But what about foreign exchange market intervention? It is a tricky instrument and, if
misapplied, yields nothing at best and generates enormous losses at worst. Refusing to use
it at all, however, would be unnecessarily extreme. One of the lessons of the financial crisis
is that the proper deployment of foreign exchange reserves can be of key importance in
preserving monetary and financial stability under difficult circumstances. This is supported by
innumerable examples from countries from Brazil to Korea. There is no benefit in amassing
foreign exchange reserves during an economic upswing if one is chary of using them in times
of need. The public sector can take a broader view than the private sector because it is able
to take a longer-term position with or against its own currency, thereby smoothing out cycles,
and profit on the whole arrangement. Australia and other countries have at times used this
strategy successfully, in spite of an inflation target. But there is no sense in protecting an
unrealistic exchange rate through thick and thin, nor does it make sense to draw a line in the
sand vis-à-vis the market. Under those circumstances, it is better to adopt the military
strategy of Genghis Khan, who often began by retreating, luring his opponents from their
fortresses and then annihilating them out on the steps.
At present, foreign exchange market intervention in Iceland aims at mitigating exchange rate
volatility and preventing a spiral of currency depreciation and expectations of further
depreciation. Since the banks collapsed, the Central Bank's foreign exchange market
intervention has all been in one direction: It has sold foreign currency. In the past few
months, however, intervention has been reduced significantly in comparison with, for
example, January and February, and then May and June. Nonetheless, 2009 figures
year-todate are quite high, at over 80 million euros.
Is too much risk being taken? As long as intervention remains modest, I think not. There is
no doubt that the equilibrium exchange rate of the króna has fallen sharply after the past
years' accumulation of debt and the ensuing collapse of the banking system. I think there is
little doubt that the current exchange rate is below this new, lower equilibrium rate, as is often
the case in a financial crisis. However, there is great uncertainty about how far below
equilibrium it is. There is also considerable uncertainty about how much the equilibrium
exchange rate will rise in coming years and how much the exchange rate will correct itself.
The Central Bank's newly published forecast assumes that the exchange rate of the króna
against the euro will remain close to current levels until well into 2010, whereupon it will
gradually rise to about 170 in 2011 and 2012. We hope, of course, that this forecast is unduly
pessimistic, and experience tells us that the currency can appreciate swiftly once it gains
upward momentum. But it would be imprudent to base plans and policy actions on such a
hope. On the contrary: I believe we should prepare ourselves for a protracted episode of
weakness. And, like so many other things, there are both pros and cons associated with
such a development.
That doesn't change the fact that we would all have to make a concerted effort to botch
things in order to prevent the exchange rate from being considerably higher in a few years'
time than it is today. But then we will have to remember to buy back the foreign exchange
that we have used to support the króna in 2008 and 2009. If we do that, then we might profit
on the whole arrangement.
I expect this spurs questions about whether we need all of the loans that we have negotiated
as a part of the IMF programme. In my opinion, this is an eminently justifiable question. First
of all, we need the loans in order to ensure that we have sufficient foreign exchange at all
times to enable us to pay amortisation and interest on the foreign debt of the Treasury and
Treasury-guaranteed entities. As far as the Treasury is concerned, there will be little activity
until late in 2011, when a loan of one billion euros, taken in 2006 to reinforce the foreign
exchange reserves, will mature. But we can also use the loans to buy the bonds from this
series and others offered in the secondary market at low prices, thereby easing the debt
service burden and profiting on the whole arrangement. Furthermore, we will need reserves
in order to engage in moderate foreign exchange market intervention, with the aim of
supporting the króna and reducing volatility. And last - but certainly not least - we need
reserves in order to create confidence in the króna and fend off those who would attack it.
But such an arsenal, which is only to be used in an emergency, is extremely expensive
because it is impossible to invest the reserves at rates comparable to those on the loans
themselves without taking an unacceptable amount of risk. Thus it is important to avoid
borrowing more than necessary and to emerge as soon as possible from our current state of
imbalance.
Before I turn to the economic outlook and the Monetary Policy Committee's most recent
interest rate decision, I consider it necessary to say a few words about the nature of the
adjustment the Icelandic economy is currently undergoing. First of all, it should be borne in
mind that the year 2009 would have been extremely difficult in any case, no matter whether
the banks had collapsed or not. This is because of the huge macroeconomic imbalances that
developed in the Icelandic economy in 2005-2007 and had to subside in one way or another.
Second, the collapse of the banking system called unavoidably for an additional adjustment
in the structure of the economy. We can summarise this as follows: The enormous current
account deficit had to go, and the financial system and various other bubble-related
operations had become far too large and had to be downsized. This involves considerable
unemployment, partly because of layoffs in the sectors that have contracted and the lag time
before new commercial activities can be established. Tradable sectors must be reinforced.
The key to hastening that process is re-establishing an effective financial system. Although
the currency may have played a role in creating the problem, the depreciation is also part of
the adjustment, and it is accompanied by transitory inflation. However, when the adjustment
is over, we should not be faced with persistent inflation, and it is the chief role of monetary
policy to try to ensure that inflation does not become entrenched.
The Central Bank published a new macroeconomic forecast yesterday, as well as
announcing the Monetary Policy Committee's interest rate decision. The highlights are as
follows:
• GDP will contract by about 81⁄2% in 2009 and by almost 21⁄2% in 2010.
•
The contraction for 2009 is rather smaller than previously forecast.
•
Private consumption has declined less sharply so far in 2009, probably because
disposable income rose more in 2008 than previously forecast, and because of
pension fund payouts amounting to some 11⁄2%of GDP in 2009.
•
In addition, unemployment has risen less than previously projected.
•
Recovery will begin in early 2010, in the sense that quarter-on-quarter GDP will
begin to grow.
•
At that point, however, Icelanders will still consider the situation unfavourable, and it
will keep deteriorating for a while, as unemployment and the output slack will
continue growing well into the year, as will the contraction in private consumption.
•
As the second half of the year progresses, these factors, too, will begin to improve.
•
As always, these projections are uncertain, and the economic recovery could prove
stronger or weaker. For example, one of the alternative scenarios in the new
Monetary Bulletin assumes a considerable delay in the construction of the Helguvík
aluminium smelter and related power facilities, with the bulk of the development
taking place in 2012. Economic recovery is delayed, and the contraction in GDP will
be 4% in 2010, instead of just under 21⁄2%.
•
Inflation has been higher than forecast in the recent term, as a result of a weaker
króna and a slightly smaller output slack than previously projected.
•
Inflation will subside quickly in 2010, however, and underlying inflation will be at or
near target in the latter half of the year.
As regards the current economic situation, the outlook I have described here, and indicators
that private sector balance sheets are somewhat less exposed to exchange rate risk than
previously thought, the Monetary Policy Committee decided to make changes in Central
Bank interest rates that entail an unchanged or slightly more relaxed monetary policy stance.
The main change, however, involves adapting the Central Bank interest corridor to the
effective level of monetary restraint, which is currently determined primarily by interest on the
Bank's current accounts and certificates of deposit. If the króna remains stable or
appreciates, and if inflation falls as forecast, then the preconditions for further monetary
easing should soon be in place.
Available forecasts assume that the Icelandic economy will recover in the next few years. We
also hope we will be quick to escape the fetters of the capital controls and the predicament
faced by monetary policy as a result of the debt crisis and the large proportion of
foreigndenominated debt. It will then be time to determine a new monetary policy framework.
Joining the European Monetary Union could be an option in due time, but it is not a certainty,
and in any event, it will take some time to materialise. The most obvious choice is therefore
to adopt some sort of inflation target and floating exchange rate. That is a topic for another
speech, but for the moment, suffice it to say that the experience of the past several years,
both in Iceland and elsewhere, indicates that such an inflation-targeting regime would have
to be somewhat different than the pre-crisis regime. It must be much better supported by
fiscal policy, macroprudential financial market regulation, and effective financial supervision.
It would have to be an "inflation target-plus" framework, which would specifically include
accumulating foreign exchange reserves during upswings in the exchange rate cycle and
using them in times of need.
Thank you.