In short, monetary policy with a flexible exchange rate is much more successful now than it had been before 2012, when the Bank published its report entitled Iceland’s currency and exchange rate policy options.3 Chart 5  1  Special Publication no. 4, Monetary Policy in Iceland after capital controls. Report from the Central Bank of Iceland to the Minister of Economic Affairs, December 2010: https://www.sedlabanki.is/library/Skraarsafn/Serrit/Peningastefnan_eftir_hoft.pdf 2 Special Publication no. 11. Monetary policy based on inflation targeting: experience since 2001 and post-crisis changes, September 2017: https://www.sedlabanki.is/library/Skraarsafn/Serrit/Serrit_nr_%2011.pdf 3 Special Publication no. 7. Iceland’s currency and exchange rate policy options, September 2012: https://www.sedlabanki.is/library/Skraarsafn/EMUskýrsla/Valkostir%20Íslands%20í%20gjaldmiðils-%20og%20gengismálum.pdf  6  Capital flow management tool There have been proposals in the media recently to the effect that the special reserve requirement on foreign capital inflows for investment in the bond market and in high-yielding deposits be immediately reduced or even eliminated. In a Box in the newly published Monetary Bulletin, the Bank discusses this special reserve requirement. It does not agree with these proposals. The special reserve requirement has functioned as intended, and monetary policy transmission along the interest rate channel has improved, as can be seen at the right in Chart 6. Without it, monetary policy transmission would have been shifted in greater measure to the exchange rate channel, leading to a stronger appreciation and increased exchange rate volatility, which would not have been terribly popular under current conditions. Although the goal is to lift the special reserve requirement, conditions do not warrant it as yet.

The current account surplus is projected at 2% of GDP by the end of the forecast horizon and could easily be eroded by a surge in demand and/or lower export revenues. 2  Chart 1  As Chart 2 shows, both private consumption growth and rising house prices are due mainly to increased real incomes and households’ improved financial position. This differs greatly from the situation in pre-crisis Iceland, where increased household leverage played a leading role, but as can be seen in the chart on the right, lending to households has not increased in real terms since 2012. Chart 2  The fact that inflation has been low in recent years despite steep rises in wages and house prices stems primarily from two things: on the one hand, positive supply shocks in the form of strong export growth and improved terms of trade, which have pushed the exchange rate of the króna upwards, and on the other hand, price deflation in international goods trade. Import prices have therefore fallen steeply in krónur terms, as can be seen at the left in Chart 3. What would happen when this imported deflation turned around was always a source of concern. Such a development now appears to be on the horizon, as can be seen in the chart. But fortunately, the rise in unit labour costs seems to be losing pace, as can be seen in the chart at the centre, and house prices appear to have 3  peaked.