davið oddsson : review of the icelandic economy address by mr davið oddsson, chairman of the board of governors of the central bank of iceland, at the bank ’ s annual meeting, reykjavik, 31 march 2006. * * * chairman of the supervisory board, prime minister, cabinet ministers, ladies and gentlemen : on behalf of the board of governors of the central bank of iceland i welcome you all to the 45th annual meeting since the central bank was established on april 7, 1961. the bank ’ s financial statements for the year 2005 have been ratified today by the prime minister. the bank ’ s annual report has also been published. it includes a report on the bank ’ s performance and a summary of how it has implemented its mandatory role. the chairman of the supervisory board devoted part of his address to birgir isleifur gunnarsson, the former chairman of the board of governors. the present governors endorse his words wholeheartedly. in this context i would like to draw attention to two points that the former chairman of the board of governors mentioned at the last annual meeting. one concerned the bank ’ s forecast for inflation and the current account deficit. at that time the bank forecast that the current account deficit would be equivalent to 12 % of gdp in 2005 and inflation would be 2½ % by today. now it is clear that developments have been less favourable than was forecast and hoped. the current account deficit ended up at 16. 6 % of gdp and inflation is currently 4. 5 %. institutions are admittedly not accustomed to drawing attention to their forecasts if they do not come completely true. but what are the explanations? it has transpired now that gdp grew last year by more than was forecast, and new national accounts data also show that the figure for 2004 was hugely underestimated. gdp growth then was 8. 2 %, the highest figure in iceland since 1987, which was effectively a tax - free year [ when iceland moved onto a paye tax system ]. last year was eventful on the economic front. private consumption grew at its fastest rate since 1987 and gross fixed capital formation faster than any year since 1971. import growth has not been as brisk in any year since 1953 and the current account deficit broke previous records – although it should be added that as a result of income from soaring foreign asset holdings, iceland ’ s net external position only deteriorated slightly. real wages were at a peak, unemployment at a minimum and direct foreign inward investment ran

at a massive level. this inflated picture must be seen in the light of the very robust economic growth in the previous year, 2004, and strong growth in 2003 as well. besides these large movements, a structural change in the domestic credit market made much more capital available to mortgage borrowers. higher disposable income and net wealth also contributed to making this a unique period in icelandic economic history. bearing all this in mind, it is probably surprising how modest a deviation was actually shown from the forecasts for inflation and the current account deficit. so far, house prices have been the main driver of inflation above the target. if house prices alone are excluded, iceland ’ s rate of inflation is low – and also in comparison with other european countries, for example. house price inflation was widely expected to stop sooner than it actually did. monetary bulletin, which was published yesterday, describes how the financial position of households has tightened due to a rise in short - term interest rates and in the lowest rates for new mortgages, compounded by the depreciation of the krona and higher inflation. for a number of familiar reasons, however, these monetary effects are not felt strongly yet, which is dampening efforts to slow down the economy. the increase in mortgage interest rates following yesterday ’ s rise in the central bank ’ s policy rate, however, represents an important contribution now. private consumption grew by almost 12 % last year. growth at such a pace is rare and can only be short - lived. disposable income has been driven up by wage rises, a higher employment rate and tax cuts. household wealth has also grown as real estate and equity prices rose substantially. most indications are that asset prices are the main driver of private consumption growth. housing prices in the greater reykjavik area went up by 45 % over the past year and a half, and equity prices by almost 96 % over the same period. in the central bank ’ s view, the real estate market will cool down significantly in the near future and private consumption growth will normalise next year. it might seem natural to ask whether the bank ’ s concerns about inflation will not vanish overnight then, because housing prices have been the only factor keeping inflation figures high. unfortunately the matter is not so simple. there is no doubt that the central bank ’ s policy rate measures have played a crucial part in helping the other index components to counteract house price inflation in the recent term. the movements in the exchange rate of the krona in