. 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 special publication no. 7. iceland ’ s currency and exchange rate policy options, september 2012 : https : / / www. sedlabanki. is / library / skraarsafn / emuskyrsla / valkostir % 20islands % 20i % 20gjaldmiðils - % 20og % 20gengismalum. pdf 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. it will probably be necessary to scale it back in increments as demand pressures in the domestic economy recede and growth in trading partner countries gathers more momentum. current forecasts indicate that this will happen, as can be seen at the right in the chart. long - term interest rates will reflect this, and the longterm interest rate differential will narrow. chart 6 another important factor is that it is unclear what benefit the investments affected by the capital flow management measure have for iceland at present. the treasury ’ s borrowing need is limited in historical context, and strictly speaking, the treasury does not need the funds generated by the bonds in question. if the special reserve requirement were not in effect, the central bank would probably have to hold larger foreign exchange reserves so as to mitigate the risk associated with carry trade - related inflows and the potential for sudden outflows. this would be quite costly, as the global market returns on the reserves are unusually low at present. at the same time,

should have had on mortgage lending rates, including those of the hff. it should be added that changes in economic aggregates are more difficult to measure in the national accounts during rapid growth episodes, as shown by sizeable revisions to leading preliminary estimates. when the central bank raised its policy rate in 2004 and 2005 to counter mounting inflationary pressures, it did so on the basis of available data on macroeconomic conditions that later turned out to give a misleading picture of real developments. revised statistics published last year showed that the economy expanded by much more in 2004 and 2005 than could be read from data at hand when the central bank hiked its policy rate during those two years. when the real outcome was known, it was obvious that the central bank should have raised its policy rate by more and faster than it did at the time. monetary policy faces the challenge that the best available data are always imperfect, but especially so during periods of rapid change. as i mentioned earlier, the central bank left its policy rate unchanged on the last interest rate decision date, february 8. in december it raised the rate to 14. 25 %. this was the eighteenth hike since may 2004 ; prior to that, the policy rate had been held at 5. 3 % for more than a year. the central bank noted that its december hike seemed to come as a surprise. the introduction to monetary bulletin, which was published on november 2, stated that a reduction in the policy interest rate was still not in sight, in spite of substantially brighter inflation prospects. on the contrary, it was impossible to rule out a further policy rate hike in order to attain the inflation target within an acceptable timeframe, and the analysis presented then implied that there were still grounds for tightening the monetary stance further. however, the board of governors had decided to postpone such a measure for the time being. the next interest rate decision, to be announced on december 21, 2006, would be based on the analysis in the november monetary bulletin and additional data that became available by that time. the chairman of the board of governors underlined this message from monetary bulletin in a speech a few days later when he described the decision to leave the policy rate unchanged on november 2 as a deferral of an increase rather than the end of the tightening of the stance. when it was decided to raise the policy rate on december 21, it was known that inflation had slowed down to considerably below the midyear forecast rate. inflation was mainly brought down by lower energy prices,