The presence of the Housing Finance Fund in the mortgage market and its state guarantee distorted the market and hindered policy rate increases from being reflected in mortgage rates. Moreover, the Central Bank was not able to sufficiently affect expectations in the market with its decisions and pronouncements. This significantly changed in early 2007 when the Bank began, like the Central Banks of Norway and Sweden for example, to publish a future policy rate path. That change greatly improved the communication and transparency of monetary policy and significantly strengthened the transmission mechanism as policy rate decisions were much more effectively reflected through the maturity spectrum. The Treasury has delivered surpluses over a number of years. They and the privatization proceeds from earlier years were used to retire debt, leaving the Treasury currently without debt in net terms. In fact, the Treasury earned net interest income in 2007. Its deposits in the Central Bank are currently equivalent to roughly 12% of GDP. Nevertheless, it is evident from developments over the last few years that fiscal policy was not sufficiently tight to aid monetary policy in containing inflation. Domestic demand has been slow in responding to tightened monetary policy. The higher policy rate meant that the Icelandic króna became an attractive investment vehicle for foreign investors. International issuance of Icelandic krónur bonds commenced in 2005 with relatively lively issue activity – albeit fluctuating – into the early part of this year. It followed a pattern very similar to that experienced by New Zealand.

To conclude on the economy, in its monetary policy statement issued on the occasion of the latest policy rate decision on April 10, the Board of Governors once again stated that the Bank’s most critical task was to reach the inflation target as soon as possible. The demand shocks of the past few years and unusual conditions in the global financial markets had delayed that process. There was no reason to surrender any ground in the battle against inflation. Thus the Central Bank continues to be fully committed to the inflation target. Financial sector You are familiar with the expansion of Icelandic banks to other countries, including Norway. This development followed the banks’ full privatization a few years ago. The three major banks all expanded their activities to other countries but followed different strategies. The record shows that their investment in financial services companies abroad was generally very sound. They have good and solid operations in other countries. Because of this development, the banks have become less Icelandic and more Northern-European, as demonstrated among other things by the fact that in 2007 the three biggest commercial banks derived more than half of their overall income from activities outside Iceland and the biggest bank derived about two thirds of its income from operations outside Iceland. They are therefore much less sensitive to cyclical developments in Iceland than before, or in any one country for that matter. The risks are much better spread than before. 2  4  Central Bank of Iceland: Monetary Bulletin 2008/1.