terms of trade has created greater scope for non - inflationary wage increases. this is true, to the extent that the improvement is not merely transitory. but even if it is merely transitory, it keeps inflation from rising above target for a while, even if wage increases are well in excess of the level that is consistent with the target in the long run. another possible explanation is that the equilibrium real exchange rate is rising at present because of the improvement in terms of trade and the reduction of external debt, owing in part to the settlement of the failed banks ’ estates and the release and tying - up of offshore kronur. to the extent that this does not surface in a nominal currency appreciation, it will put temporary pressure on wages and prices. it seems to me that a number of signs indicate that all of these explanations apply to some degree. but the consequences for economic stability will be determined, among other things, by the weight of each one and by the response of monetary policy and other economic policies. in any case, it is clear that something has to give. as chart 1 shows, we are undergoing a period of several years during which unit labour costs are growing well in excess of the level that is consistent with the inflation target. at the same time, productivity growth is very weak. bis central bankers ’ speeches if the central bank ’ s most recent forecast materialises, the result will be as is shown in chart 2 : the real exchange rate and wage share will rise far above their historical averages, and the tension in the labour market will be amplified even further. but i consider it unlikely that this will be the outcome. either the adjustment will take place through some combination of higher inflation and higher unemployment, or positive shocks will provide some assistance ; for example, the improvement in terms of trade will be greater and more lasting, productivity growth will be stronger, and interest payments to abroad will be lower because of reduced external debt and improved credit ratings. it will be very interesting to see how things develop in the next few years. it would be imprudent, however, for economic policy and contingency planning to rely blindly on positive shocks. and then there is inflation. inflation has risen more slowly following the recent pay hikes than perhaps could have been expected in view of historical experience, and it is still well below target. this could be due in part to the additional scope provided by the favourable initial position of many firms and by the improvement in terms of trade. but the

financial system risk more effectively than we did previously, and we are developing prudential rules and macroprudential tools to respond to systemic risk. this will make the conduct of monetary policy easier. and in addition, i hope that statutory amendments will be passed soon in order to put brakes on foreign - denominated lending to resident borrowers without foreign currency income and assets. but the final brushstrokes remain undone : we have yet to develop tools that can be used to reactivate the interest rate channel if and when it becomes clogged up because of capital inflows related to carry trade. in this context, one might ask whether we are too late. to be sure, the capital inflows are taking place sooner than generally expected. we still have not released those who entered last, but we have already received capital inflows of nearly 50 b. kr. for investment in nominal treasury bonds – most of it after iceland ’ s sovereign ratings were upgraded because the next steps towards capital account liberalisation were announced in early june! and this has certainly disrupted the monetary policy transmission mechanism, as can be seen in chart 4. thus far, the impact has been more or less limited to the treasury bond market, and the banks ’ nominal interest rates have broadly followed central bank rates. the first signs of contagion to other parts of the financial market had begun to show before the central bank ’ s rate hike yesterday. it will be interesting to see what impact the rate hike has. independent monetary policy entails the possibility of maintaining a different monetary stance than other countries do if and when the need arises. recent research and international discourse indicate that it can be difficult for small, open, and financially integrated economies to pursue monetary policy that differs significantly from that in large economies. the final brushstrokes entail developing tools that will, if applied, restrict the benefits accruing to nonresidents as a result of our having higher interest rates than our trading partners. the precise structure of this will come clear in the next few months, but possibilities include some form of taxation or a special reserve requirement. central bank of iceland special publication no. 4 : monetary policy after capital controls, december 2010 and central bank of iceland special publication no. 6 : prudential rules following capital controls, august 2012. http : / / www. cb. is / publications / publications / special - publications / bis central bankers ’ speeches i have now reviewed the multiple crossroads that