The evidence suggests that foreign exchange markets exhibit excess volatility and that exchange rates diverge from fundamentals for protracted periods. In some sense, the existence of carry trade can be construed as evidence of this, as it involves betting that interest rate differentials are not fully compensated by exchange rate movements; i.e., that uncovered interest rate parity does not hold, except at long horizons, and then often through sharp and disorderly corrections. This, in turn, gives rise to two concerns: first, regarding detrimental effects on the traded goods sector , and second, on financial stability where volatile capital flows, currency mismatches, and rollover risk of foreign currency debt are among the key players. Adverse effects on financial stability can be particularly severe when a blocked interest rate channel and an erratic exchange rate channel interact badly with other economic and financial risks that can face small, open, and financially integrated economies – such as the global financial cycle, domestic financial vulnerabilities, and policy conflicts. We saw trends before the GFC that were consistent with this story. Data on longterm interest rates and spreads in small advanced economies and in many emerging markets economies showed strong and growing correlations with longterm rates and spreads among core rate setters (mainly the US and the eurozone), although still some way from the theoretical limiting case. The GFC reversed this process somewhat, as risk premia skyrocketed, cross-border banking partly retreated to home base, and restrictions on capital movements were in some cases reintroduced.

The problem with both is that other policies, such as fiscal policy, will then have to take care of domestic economic stabilisation. But will they? Third, they can use FX intervention to reduce the effect of volatile capital flows on the exchange rate. Fourth, they can increase resilience and the ability to live with exchange rate fluctuations (reduce the fear of floating) by strengthening financial regulation and supervision or employing macroprudential tools. Fifth, if everything else fails, they can introduce tools aimed directly at the financial integration part in order to regain greater monetary independence and shift the effect of monetary policy more to the interest rate channel and towards the non-traded goods sector. These so-called capital flow management measures are probably most needed when countries are faced with large capital inflows at the same time as domestic conditions warrant significantly higher interest rates than among core rate setters. In Iceland, we have used many of these tools in recent years. We have used FX intervention to reduce short-term exchange rate fluctuations and, in recent years, to lean against strong appreciation pressures. We have introduced a liquidity coverage ratio and a net stable funding ratio in foreign currencies. In 2016 we were faced with strong capital inflows that flattened the yield curve as the policy rate was being increased and more was signalled. We then introduced a special 2  Rey (2013) and Obstfeld (2015) analyse this issue and provide somewhat different views on whether it is a dilemma or a trilemma.