appreciation of the krona after the middle of the year, the effect of lower global fuel prices on the price level, and the fact that wage settlements made in the middle of the year did not provoke wage drift on the scale that the bank had forecast in july. the first two factors were hardly foreseeable, and it should be pointed out that the bank ’ s overforecast for wage drift was not far from that made by the social partners themselves when the wage settlements were signed. be that as it may, the economy was no less overheated than forecast in mid - 2006, as witnessed by the current account deficit and tight labour market. thus it is untenable to claim that the central bank ’ s policy rate hikes in 2006 were unwarranted. on the contrary, a higher policy rate was the main precondition for the krona to hold relatively strong, and contributed to subduing demand growth. had the central bank not raised its policy rate, there is little doubt that inflation would be higher than at present. some commentators who were surprised by the december policy rate hike apparently considered that the central bank had underestimated the scope of the turnaround in the economy in the second half of the year. national accounts statistics for q3 that were published in mid - december, supposedly showing a substantial slowdown in economic activity, were repeatedly cited as evidence. the central bank considers it imprudent to draw sweeping conclusions solely from preliminary estimates in the quarterly national accounts, which tend to undergo sharp revisions. for this and other reasons, a broader range of indicators contributed to the december policy rate decision, including the current account deficit and labour market conditions. the scenario today is that commercial bank analysts expect the cycle of policy rate cuts to begin later this year than they were forecasting towards the end of 2006. in other words, they consider that more underlying pressures remain in the economy than they may have thought at the time. interest rate assumptions in central bank forecasts various changes have been made to the exchange rate and interest rate assumptions behind the central bank ’ s forecasts in recent years. in the early years of inflation targeting, forecasts were based on the assumption of an unchanged exchange rate and unchanged policy rate over the forecast horizon. by showing how developments would unfold if the bank left the policy rate unchanged, they indicated whether it needed to be changed. in december 2004, the first alternative scenarios to the baseline forecast were presented which assumed changes in the exchange

a fluctuation range. the reason is not least that it proved increasingly difficult to adhere to a fixed exchange rate policy in a world of deregulated capital movements. it could be said that prevailing opinion identified only two possible exchange rate options : a floating exchange rate or a completely fixed one, for example through membership of a currency union, unilateral adoption of some other currency or establishment of a currency board. the new policy has produced good results and is applied in countries including sweden, norway, the uk, australia and new zealand, along with several countries in eastern europe, latin america, asia and africa. it can also be argued that the european central bank partly follows the same kind of policy. from all the above it is clear that the central bank of iceland has undertaken the major responsibility of ensuring price stability, which in the sense used in the joint declaration by the government and central bank means a twelve - month rise in the cpi of 2½ %. it is not the central bank ’ s role to ensure a specific rate of growth or level of employment, since its instruments are incapable of having any impact on them in the long run. however, it is acknowledged that ensuring price stability creates vital preconditions for economic growth and prosperity. inflation increased substantially this year and in june it passed outside the tolerance limits as defined in the march declaration. according to the central bank ’ s inflation forecast published in early august, the outlook that inflation would rapidly decelerate towards the end of this year and the beginning of the next, then would move inside the tolerance limits in the middle of next year, and the 2½ % target would be reached in mid - 2003. the forecast was based on the main assumptions of an unchanged exchange rate from the forecast day, a cooling of the economy and no wage rises in excess of agreements that had already been negotiated. the central bank will publish its next inflation forecast on november 8. tight monetary stance the central bank has applied a tight monetary stance for some time now, as reflected in its high policy interest rate. the policy rate is the rate of interest applying to the central bank ’ s repo transactions with credit institutions, i. e. interest on liquid funds that they borrow from the bank. monetary policy has been the subject of lively debate in recent weeks and months and the bank has been under steady pressure to cut interest rates. as the central bank has repeatedly underlined, its viewpoint has been that lowering interest rates entails a greater risk than