5 april 2018 speech mar gudmundsson, governor of the central bank, delivered at the 57th annual meeting of the central bank of iceland, 5 april 2018. mr. president ; prime minister, other ministers, speaker of parliament, directors and ambassadors ; ladies and gentlemen! the icelandic economy has been in fine fettle recently, with full employment, to say the least, as we have had to import a large number of workers to support economic activity. the risk of overheating has receded somewhat in the past year, however ; the positive output gap has narrowed, and the residential housing market is less stretched than it was a year ago. until last month, inflation had been close to target but below it for four years running. inflation expectations have been at target by most measures in the recent past. it is this that has enabled the bank to lower its policy interest rate by 0. 75 percentage points since our last annual general meeting. inflation expectations have fallen to the target and have become more firmly anchored there, reflecting the success of monetary policy in the recent term. the bank ’ s chief economist recently published a working paper explaining this success, noting as well that the decline in inflation to the target between 2012 and early 2014 was virtually costless, partly because of increased credibility of monetary policy. 1 if changes are made to the monetary policy framework in the coming term, it is important to preserve this success. one of the main reasons for reduced demand pressures in the economy is that gdp growth has subsided after peaking in 2016 and is now approaching its longterm trend rate. the slowdown in gdp growth reflects weaker export growth, as the tourism boom cannot be expected to continue at the pace seen in the recent past. furthermore, the improvement in terms of trade has slowed down considerably. this means that the effects of the positive shocks that enabled us to grow rapidly and simultaneously keep inflation low are tapering off. the appreciation of the krona played a major role in the economy ’ s adjustment to these shocks. however, the bank intervened in the foreign exchange market and imposed a special reserve requirement ( srr ) on capital inflows to prevent the thorarinn g. petursson ( 2018 ), „ disinflation and improved anchoring of long - term inflation expectations : the icelandic experience “, central bank of iceland working paper no. 77. this improved performance of monetary policy is also discussed in detail in central bank special publication no. 11, entitled “ monetary policy based on

1 ). most of this expansion was cross - border, and a significant part of it was actually off - border, having very little to do with iceland, as both financing and investment took place abroad. around two - thirds of the balance sheet of the three cross - border banks was denominated in foreign currency. as is typical for banks, the fx part of the balance sheet had a significant maturity mismatch. however, there was no safety - net of the type that we have at the national level to back it up. this turned out to be the fatal flaw in the whole setup. why were these big risks allowed to build up? i do not think we yet have the research and the consensus to provide a reasonably undisputed list of the main causal factors in this process ; however, i think four factors will rank highly on that list. the first of them is iceland ’ s membership in the european economic area ( eea ) beginning in 1994, which made it possible for the banks to operate more or less freely throughout the area on the basis of home licencing but with national supervision, safety net, and crisis management and resolution. the other three causes are the privatisation of the icelandic banking system in the early 2000s in a manner that placed the major banks in the hands of risk - loving investment bankers, the global conditions of ample and cheap credit that prevailed in the years prior to the international financial crisis, and the tendency in iceland both to adopt international and eu regulations without critical analysis of iceland - specific risks and to base supervision to a significant degree on mechanical checks of adherence to those regulations. in the panic that gripped global financial markets after the collapse of lehman brothers, these banks were faced with a wholesale run on their foreign currency liabilities and were therefore heading towards a default on those liabilities in the absence of lolr assistance in foreign currency. however, given the size of the banks, it was impossible for the icelandic authorities to provide such assistance on their own. there was actually a plan to nationalise one of the banks in late september 2008. fortunately it failed, as nationalising the bank would have turned a private bank ’ s foreign currency refinancing problem into a sovereign problem, with the serious risk that the sovereign might have defaulted on such foreign currency payments, thus initiating a full - scale sovereign debt crisis. figure 2 gives a sense of the potential scale involved in the case of the three banks, by comparing the foreign currency liabilities of the