30 March 2017
Speech
Már Guðmundsson, Governor of the Central Bank,
delivered at the 56th Annual Meeting of the Central Bank of Iceland, 30 March
2017.
Prime Minister, Minister of Finance and Economic Affairs, Speaker of
Parliament, bank directors, foreign ambassadors, ladies and gentlemen!
We have come together today for the 56th Annual Meeting of the Central Bank
of Iceland. At the time of last year's meeting, the domestic economy was
considered relatively strong. GDP had risen above the pre-crisis peak. National
income had risen even more in recent years because of improved terms of trade.
Unlike many previous periods of full employment, the economy was well
balanced internally and externally, as could be seen in a two-year period of
inflation at or below target and a sizeable current account surplus. This was a
good position, but we also realised that it could be fragile, as demand pressures
were mounting and there was a real risk of overheating. Developments
internationally had been favourable for us in many ways, but the tide could turn.
We therefore needed to be on the watch, and economic policy had to take this
risk into consideration.
Then what do we say now, when growth has accelerated even further and
demand pressures are even greater, yet inflation has remained below target,
inflation expectations have subsided to target, the 2016 current account surplus
was at a historical high, and we own more than we owe abroad? In addition, the
policy interest rate was lowered by 0.75 percentage points last year, the króna
has appreciated by over 16%, the Central Bank has bought more than 350 b.kr.
worth of foreign currency, the foreign exchange reserves have grown by over a
third in foreign currency terms, and capital controls have been almost completely
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lifted in three large steps. These are substantial changes in a single year
changes that will presumably take their place in economic history.
What lies behind these developments? How could the domestic economy grow
by more than 7% in 2016 without overheating and unleashing inflation? Five
major factors are presumably of considerable significance whose mechanism it
is important to understand in order to assess what comes next and formulate
appropriate economic policy responses.
First of all, the supply side of the economy is more flexible than before, owing
to increased economic integration with the rest of the world. The EEA
Agreement plays a large role here, but so do other trade related agreements and
general market-driven developments in the global economy. Because of this,
when demand pressures start to develop, it is easier than before to mitigate them:
by importing labour and other production factors, by using foreign inputs in
domestic production chains to a greater degree, or by moving a portion of
operations out of the country. Last year, for instance, net migration among
foreign nationals was closing in on the previous peak from 2006.
The second important factor is understanding the nature of the largest shock to
the economy in the recent term and how it interacts with the countercyclical role
of the exchange rate. The surge in tourism has been one of the main drivers of
GDP growth in recent years. In part, the tourism industry utilises infrastructure
and capital that were underutilised before growth in tourism took off; therefore,
the impact on the level of domestic demand was less pronounced than it would
have been if the surge had necessitated an immediate increase in investment.
Now, however, we have probably reached the endpoint as far as this is
concerned. In addition, increased tourism brings with it foreign currency inflows
that, other things being equal, will push the exchange rate upwards. This will cut
into activity elsewhere, shift demand outside the domestic economy, and reduce
inflation. To a degree, then, after full employment is reached, an automatic
counterweight develops, offsetting the pressures caused by growth in tourism.
Third, global economic developments have remained favourable to us. Terms of
trade for goods and services have improved in recent years, and foreign currency
prices of imports have fallen.
Fourth, a larger share of income is being channelled towards savings than has
often been the case in the past. Last year, gross national saving - the share of
GDP not used for private or public consumption - was nearly one-third of GDP,
one of the highest national saving rates in our history. This high level of saving
explains why last year's current account surplus was so large even though
investment had returned to its historical average. Underpinning it is increased
saving by households, businesses, and the public sector, which in turn stems
from several factors: increased caution following the experience of the financial
crisis; an improved public sector outcome; the housing market situation, where
more capital is required for a first home purchase; and the level of interest rates.
A higher level of saving reduces excess demand in the economy.
The fifth factor is the success of monetary policy in the recent term. This can be
seen in short- and long-term inflation expectations, which have been at target
since mid-2016. In addition, expectations appear more firmly anchored to the
target than before, which shows in the fact that exchange rate volatility and
unexpected changes in inflation have less impact than they did in the past. The
inflation target has therefore gained credibility. As a result, it takes more to move
inflation away from the target than in the past, and inflation can be kept at target
over the medium term with lower interest rates than was previously possible. By
the same token, the possibilities for monetary policy to mitigate fluctuations in
economic activity without jeopardising the inflation target are greater.
What is the current situation, in light of these explanations? In some respects,
the current situation is similar to that a year ago. For this year, it is forecast that
GDP growth will remain well above long-term growth in potential output and
demand pressures will still increase, but that inflation is projected to remain
below target for most of the year. This is uncertain, however, and various
changes have taken place and others may lie ahead, which could affect future
developments. The tradable sector is now experiencing stronger crowding-out
effects from tourism, after the rapid growth of the latter in recent years. Sizeable
pay increases in the recent term and last year's
strong appreciation of the króna
cut into profits, and companies now have less scope to absorb pay rises. The
recent appreciation of the króna is a result of growth in tourism and other
favourable developments, and it tends to shift demand outside the domestic
economy, thereby reducing the positive output gap.
Although forecasts based on given assumptions and available models indicate
that the exchange rate will continue to rise, it should be noted that this is highly
uncertain. Capital account liberalisation could contribute to either a higher
exchange rate or a lower one in the short run, depending on how expectations
develop. The special reserve requirements imposed last June on capital inflows
to the bond market and high-interest deposits have contained the rise in the
exchange rate and will reduce the likelihood of a steep carry trade-related
appreciation in the near term. From 12 March, when capital account
liberalisation was announced, through yesterday's official listing, the exchange
rate of the króna had fallen by 3.8%.
At present, there are changes taking place in the global economy that will change
the situation to some extent. Global GDP growth is on the rise, particularly in
industrialised countries. Commodity prices are rising, and inflation in
industrialised countries appears to be increasing as well. Interest rates have been
raised in the US, and the period of very low or even negative interest rates in the
euro area may be coming to an end. This has various effects on the Icelandic
economy. It is not a given that terms of trade will continue to improve, and
imported deflation will subside as well. Domestic inflation could therefore rise
above target more quickly unless domestic pressures ease commensurably. On
the other hand, the interest rate differential with abroad will narrow, other things
being equal, and this will make the conduct of monetary policy less difficult and
reduce the Central Bank's accounting loss due to the foreign exchange reserves,
as I will discuss more fully in a moment.
Monetary policy conduct is generally much more complicated during times of
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significant change than under calmer conditions. The signposts of the policy
such as equilibrium interest rates, output, unemployment, and the exchange rate
- could begin to move. However, because these variables are not observable but
must be derived from developments in other variables, it is highly uncertain at
any given time how much they have changed once they start to move.
Furthermore, relative prices change more than they did before, but monetary
policy cannot affect them except in the short term. Sometimes it can be difficult
to distinguish between such relative price changes and a general rise in the price
level, which depends in the long run on monetary policy. In addition to this, it
can often be difficult to determine at any given time which changes are
temporary and could possibly be mitigated through economic policy and which
ones are more permanent and nothing much can be done about, at least through
monetary policy.
These are exactly the conditions we are experiencing at present. There are clear
indications that the equilibrium real exchange rate has risen with improved terms
of trade, increased national saving, and a vastly improved external position. In
addition, there are indications that equilibrium interest rates have fallen since
before the crisis, and they have probably fallen still further as monetary policy
has grown more credible and inflation expectations have been anchored more
firmly at the target. In both instances, the question of how much remains
unanswered.
As far as the exchange rate is concerned, conventional measuring methods do
not indicate that the real exchange rate is clearly above its equilibrium level. This
is supported by the Bank's
analysis, to be published next week in Financial
Stability, which shows that 85% of inflows into the foreign exchange market in
2016 were attributable to the current account surplus and transactions between
residents. Capital inflows from non-residents are much less important, and in the
latter half of the year, when the króna was appreciating the most, carry
traderelated inflows were virtually non-existent. Estimating the equilibrium real
exchange rate is very uncertain, however, and as a precaution, the Central Bank
has leaned against potential overshooting of the exchange rate by buying large
amounts of foreign currency.
In this light, it is difficult to conclude otherwise than that the appreciation of the
króna has been largely benign, in that it is based on economic fundamentals and
contributes to a better balanced economy. The Central Bank's scenario analysis
indicates that if the Bank had used policy instruments to halt the currency
appreciation in recent years, economic imbalances would have been much
greater and inflation considerably higher.
It has been a long time since the Central Bank of Iceland could fix the exchange
rate unilaterally on a day-to-day basis. The exchange rate is determined in the
interbank market and reflects underlying supply and demand for foreign
currency. But the Bank can affect the exchange rate through interest rate
decisions, foreign exchange transactions, and the application of capital flow
management measures such as the one currently in place: the special reserve
requirements on certain types of capital inflows. The exchange rate would have
been much higher if the Bank had not applied these instruments and bought large
amounts of foreign currency.
But could the Bank have gone further; for instance, by buying even more foreign
currency or by lowering interest rates more than was warranted by economic
conditions and the inflation outlook? Certainly it could have done so; it could
even have gone as far as to more or less halt the appreciation of the króna. But
then large interest rate cuts would probably have been needed alongside the
foreign currency purchases, perhaps even bringing real rates into negative
territory, which is ill-suited to an economy with a positive output gap and very
strong GDP growth. The reason is that in order to lower interest rates enough to
residents'
materially increase appetite for investment in foreign securities, an
interest rate cut of 0.25 or 0.5 percentage points would not be sufficient because
of how wide the interest rate differential currently is. It is not a given, either, that
long-term interest rates in the bond market would have followed suit in full, and
bond market rates are more important for investments by pension funds and other
investors than the Central Bank's
short-term rates are. The reason for this would
have been that inflation expectations had risen, and if the reduction in short-term
interest rates had not been in line with economic developments and prospects,
expected short-term interest rates would have increased.
This would not have occurred without severe side effects. In this context, it
should be borne in mind that in the long term, central banks can affect inflation
and can have a corresponding impact on the nominal exchange rate, but they
cannot affect the real exchange rate in the long run. If the real exchange rate rises
because of an increase in the equilibrium real exchange rate and the Central Bank
halts the rise in the nominal exchange rate, the real exchange rate will ultimately
rise in any case, through larger wage increases and inflation.
If the Bank had halted the rise in the exchange rate at all costs, inflation would
probably be well above the target already, and it is very unlikely that inflation
expectations would be at target. This would also have been inconsistent with the
Bank's legally mandated price stability objective. It would also have been quite
costly, as the credibility of monetary policy would have been gone and interest
rates in the future would need to be higher in order to restore that credibility. If
there is the will to impede the rise in the real exchange rate and mitigate the
crowding-out effect that tourism has on other sectors, which is certainly needed,
but without sacrificing price stability, it must be done with policy instruments
that can have a lasting impact on the real exchange rate, such as tighter fiscal
policy. In this context, it gives cause for concern that the fiscal stance in terms
of the cyclically adjusted primary balance has eased over the past two years and
appears likely to do so again this year. It is also possible to address the currency
appreciation at its source by applying what some representatives of the tourism
referred to as "access restrictions and pricing".
sector have appropriately
In the recent past, numerous observers have expressed the opinion that the
Central Bank's key interest rate is too high under current conditions. As grounds
for their arguments, they cite much lower interest rates in trading partner
countries, the fact that inflation in Iceland has been at or below target for three
years, and the Central Bank's overforecast of inflation in recent years.
Discussing whether the monetary stance is in line with the Bank's objectives and
current economic developments and prospects is normal and appropriate.
Opinion varies, sometimes even within the Monetary Policy Committee itself,
because reliable data on current and recent developments become available with
a time lag and the future is always uncertain.
The Bank's key nominal interest rate is now 5%, and the corresponding real rate
is about 21⁄2%. In view of the business cycle position and the fact that inflation
is below target, this implies an equilibrium real rate of 11⁄2%, which must be
considered low, given that long-run growth potential is significantly higher.
Current nominal and real interest rates are not high in historical terms, although
they are high in current international context. The explanation, however, lies in
historically very low interest rates abroad rather than abnormally high rates in
Iceland. In many economies around the world, inflation has been below target
levels and central banks have overforecast inflation in the recent past, largely
irrespective of the level of interest rates and the economic cycle in individual
countries. This indicates strongly that there are global factors at work, such as
low commodity prices and resistance to wage increases in industrialised
countries, partly in response to increased direct and indirect competition from
the labour forces of other economies and uncertainty about the future in the wake
of the financial crisis.
The current monetary stance is not affected by the Bank's previous
overforecasting of inflation. The MPC takes account of forecasts but does not
blindly set interest rates in accordance with them, and it adjusts the monetary
stance in view of developments. The forecasts themselves are revised each
quarter. One to two years ago, forecasts were based both on the technical
assumption that the exchange rate would remain unchanged at far below the
current level and on expectations of a turnaround in global commodity prices,
which international forecasts had assumed would be stronger and come sooner
than has actually been the case. These forecasts were accompanied by a future
interest rate path that never materialised. It is therefore necessary to assess the
monetary stance at any given time on its own merits. The MPC has done this and
will continue to do so. Near-term developments in nominal and real interest rate
will be determined by economic developments and the inflation outlook. The
MPC attempts at all times to keep interest rates no higher than they must be in
order to hold inflation at target over the medium term. Based on these
considerations and assuming that there are no major unforeseen changes in the
current situation, the scope for further reductions in nominal interest rates could
develop in the near future.
The Government has initiated a review of the monetary policy framework. The
Central Bank of Iceland supports this process and will participate actively in it.
It is important both to take into account what monetary policy can achieve and
to acknowledge what it cannot do. It is also important to bear in mind that
significant changes have already been made in monetary policy conduct since
the pre-crisis period, as I have discussed in detail in this setting in the past.
Nevertheless, various additional changes need to be considered, and the Central
Bank cannot change the most important element of the equation: that monetary
policy, fiscal policy, other economic policy, and decisions taken in the labour
market must pull together to the maximum extent possible. I would also like to
emphasise the importance of preserving the monetary policy achievements that
I have discussed.
Honoured guests: The Central Bank's foreign exchange reserves totalled over
810 b.kr. or 71⁄2 billion US dollars, at the end of February. This is equivalent to
about one-third of GDP. The reserves were above the minimum aimed at during
account liberalisation. Relative to GDP, Iceland's reserves
the prelude to capital
are currently at their largest since the end of World War II.
There is no doubt that we have already benefited greatly from these relatively
large reserves. They have enabled us to lift the capital controls without taking
excessive risk with economic and financial stability. The reserves play a key role
in Iceland's recent credit rating
upgrades, as can be seen in the press releases
from the rating agencies. The upgrades will lead to an improvement in the
borrowing terms offered to the Treasury, the banks, and large companies in
foreign credit markets. And last but not least, large reserves provide a buffer
against shocks in the future. They greatly increase the probability that if the
króna depreciates because the equilibrium exchange rate has fallen and the
positive output gap has closed, it will not pose a threat to stability. Many
countries have undergone such an adjustment, and a sudden collapse of the
currency such as that occurring in Iceland during the financial crisis is the
exception rather than the rule.
The benefits deriving from the reserves are therefore significant. The problem,
however, is that the benefits are distributed widely, while the Central Bank bears
the costs alone. Last year the Bank recorded an operating loss of 35 b.kr. This
was due to an exchange rate loss of nearly 90 b.kr. on the reserves, owing to the
appreciation of the króna during the year. However, it is an unrealised
accounting loss, and it would reverse if the exchange rate should move in the
opposite direction. No assets have been lost. The foreign currency value of the
reserves is unchanged, and the purchasing power in terms of what the reserves
would be used for is intact.
Other aspects of the matter are of greater concern: the negative interest rate
differential resulting from investing the reserves at historically low foreign
interest rates and the interest expense on the Central Bank's
króna-denominated
liabilities, which bear much higher interest. Extrapolations to 2025 indicate that,
other things being equal, the Central Bank will record losses of 18 b.kr. per year
from 2018 onwards, and the Bank's equity will be negative thereafter. This in
and of itself is not Armageddon, and many central banks have functioned quite
successfully with negative equity. Nevertheless, it is better for a number of
reasons if the Central Bank has an acceptable capital position. Extrapolations
carried out by the Bank show that with various measures and appropriate
distribution of the cost of the reserves among the parties that benefit from them,
the gap can be closed. Among the measures is the possibility of increasing
returns on the reserves by splitting them up into two or more tranches based on
term and yield.
The question has arisen whether the foreign exchange reserves are too large, or
in other words, whether the costs outweigh the benefits. Examining comparable
countries and the risks facing them suggests that this is not clearly the case.
Furthermore, we must not forget that foreign exchange reserves can grow rapidly
in small countries, as our own history illustrates, but they can also be depleted
more rapidly than in large countries when shocks strike. Various small countries
with their own currency and independent monetary policy have reserves equal
to a third or more of GDP, among them Israel, Peru, Singapore, Switzerland, and
the Czech Republic. Iceland is currently in the middle of the one-third of
countries with the largest reserves but, with one exception, it has proportionally
the least foreign currency reserve assets among the countries that have
established a sovereign wealth fund.
Honoured guests: I have spoken at length about monetary policy, the exchange
rate, and the foreign exchange reserves, three topics of current interest. I have
devoted less time to the financial system, which I discussed in greater depth last
year. The Bank's
Financial Stability report will be published next week,
however, and risks in the financial system will be covered thoroughly there. It is
no secret that there are growing concerns about the housing market, and it may
well be that macroprudential tools will be activated in the near future so as to
mitigate the risks attached to it. The Bank's
Financial Market Infrastructure
report will be issued early in June, and much is happening in that arena with the
renewal of payment systems and the impact of technological developments on
banks and payment intermediation.
Honoured guests: The legacies of the financial crisis have now by and large been
dealt with. We are now embarking on a new period of capital account openness.
This entails both opportunities and risks. We must seize the opportunities,
analyse the risks, and take appropriate action. To the best of its ability, the
Central Bank will contribute to this process where appropriate.
In closing, I would like to thank the Supervisory Board and the Monetary
Policy Committee for their work over the past year, and I wish to thank the
Central Bank's many colleagues and collaborators for their cooperation - not
least the Prime Minister's Office, the Ministry of Finance and Economic
Affairs, and the Financial Supervisory Authority. I would also like to thank the
financial institutions with which the Bank interacts for their cooperation.
Furthermore, I would like to thank the Parliament of Iceland, particularly the
Economics and Commerce Committee, for their collaboration. And last but
certainly not least, I want to thank the staff of the Central Bank for a job well
done over the past year.