are in play at any given time. the auction format also ensures that transfers of banking system liquidity will not be large enough to jeopardise the system ’ s stability. the foreign exchange reserves are protected as well by the requirement that investors bring foreign currency into the country and exchange it for kronur in the domestic market. this will offset the foreign exchange outflows that often accompany new investment. another important aim of the strategy is to ensure short - term treasury financing. even though significant progress has been made in controlling the fiscal deficit after the crash and halting the accumulation of unsustainable debt, it is important not to underestimate the current dependency of treasury financing on the capital controls. more than half – and, in some instances, as much as ¾ – of the stock of short - term treasury bonds is held by nonresidents. the yield on icelandic treasury debt is now a bit lower than in the euro area countries that are facing severe sovereign debt crises, and real yields are considerably lower. it is not a given that this would be so without the capital controls. if the controls were lifted today, interest rates would probably rise sharply, even though a large proportion of the investors that own these bonds are relatively at ease within the capital controls regime. without the controls, the authorities would have to take further action in order to achieve the objectives set for the coming year. it is therefore of pivotal importance to lengthen the maturity profile of treasury financing before the controls are lifted. marked progress has already been made in this area. the average duration of domestic treasury bonds has increased from 3 to 7 years. last spring, domestic pension funds and other investors purchased a sizeable supply of indexed longterm treasury bonds by participating in the first auctions under the liberalisation strategy, which were dedicated solely to investment in long treasury bonds. the aim was to lengthen the maturity profile of treasury financing and thereby reduce risk. although there has been a hiatus in the auctions and the pension funds lost interest in them after foreign stock markets fell this past summer, non - residents are growing interested in this investment option, which will continue to be available alongside the investment programme. the programme gives investors the option of buying icelandic kronur at the auction exchange rate ( near the offshore rate ) in order to invest in the domestic economy, provided they sell a corresponding amount of foreign currency in the domestic foreign exchange market. the investment programme, which was introduced in detail on 18 november,

the policy rate is high for a sustained period of time. inflationary pressure has been greater than forecasts indicated – and more than was easily dealt with – and as a result, it has proven difficult to contain inflation. it took a while before the impact of the central bank ’ s restraining measures was sufficiently felt, but considerable changes took place over the past year, when policy rate decisions made themselves felt more strongly in all areas of the credit market. in the fall and in early winter, the market also felt the weight of rapidly deteriorating global lending terms, which will undeniably support the central bank ’ s tightening measures and will reduce domestic demand and inflationary pressure, as was mentioned in the board of governors ’ announcement of 14 february. it is possible that there will be a rapid drop in domestic demand as a result of high interest rates and a tightening credit supply. at this point, however, it is impossible to assert that this will be the case. exactly when it will be possible to lower the policy rate will be determined by economic developments and outlook. precipitate interest rate reductions would push inflation upward and standards of living downward. the suggestion that it is necessary to lower interest rates in order to control inflation is absurd. indeed, it is astounding how carelessly many people seem to view inflation. furthermore, it is appropriate to stress that the central bank believes it is impossible to choose between price stability and financial stability. if we were to relax our stance on price stability, it would surely undermine the credibility of monetary policy. inflation – and no less important – inflation expectations would increase drastically, which could lead, in short order, to an upward spiral of prices and wages and falling exchange rate. even though domestic financial institutions might seem to profit, for the short term, by a depreciation in the krona and a rise in inflation, a trend in this direction would quickly take its toll on indebted households and businesses and would eventually result in loan losses. from the standpoint of financial stability, it is critical that inflation be reined in. it is also appropriate to emphasise the obvious fact that icelandic banks ’ access to foreign credit will not change if the central bank lowers the policy rate. it has been maintained that, because central banks in other countries have lowered their interest rates, the wider interest rate differential with abroad that resulted should have given the central bank of iceland the margin to reduce its policy rate this february. this is not entirely correct. as is well