The Icelandic Saga Conducting monetary policy with the smallest freely floating currency in the world through periods of ample global liquidity and credit crisis T. Tjörvi Olafsson Economist, Central Bank of Iceland Economics Department thorvardur.olafsson@sedlabanki.is Presentation at the Federal Reserve Bank of New York May 16, 2008 The opinions expressed in this presentation are those of the author and do not necessarily represent the views of the Central Bank of Iceland.

Damaging effects of the crisis …

… due to lack of confidence …

... reflecting domestic vulnerabilities

Sharp turnaround underway

Overview Rapid expansion in times of ample global liquidity, large demand shocks and the build-up of large macroeconomic imbalances Challenges of independent monetary policy in very small open economies unwinding these imbalances Out-of-sync with the global monetary cycle Importance of credibility and transparency Financial accelerator/decelerator mechanisms, carry trade and sudden-stops Main task of monetary policy: Restore confidence Anchor inflation expectations and stop the rapid depreciation of the Icelandic currency Liquidity provision in foreign currency

Basic information on Iceland Very small open economy: 300,000 inhabitants From poverty to riches in the 20th century through utilisation of its abundant natural resources Historically a volatile economy due to resource-based exports and external supply shocks Controlled economy for a longer period than most other developed countries History of high and volatile inflation Significant structural reforms over the past two decades Market liberalisation, privatisation, fiscal consolidation Disinflation in 1990s but unsustainable fixed exchange rate regime Inflation targeting since 2001 Diversification of the economy and embracement of globalisation Still high exchange rate pass-through

Inflation targeting adopted in 2001 New Central Bank Act in May 2001 and a joint declaration of the government and the bank Significant departure from previous regimes of different types of currency pegs Long history of using the exchange rate as a monetary anchor with a varying degree of commitment resulting in high inflation

Price stability main objective … Price stability defined as the Bank’s single main objective Inflation target specified as inflation of 2½%, measured in terms of twelve-month rate of change in headline CPI (house prices included) The Central Bank granted full independence to attain its objective Transparency and accountability strengthened In line with best practice around the world

... but expectations remain unanchored

Disappointing results Inflation has on average been 4.9% since inflation targeting was adopted in 2001 Inflation has been volatile, it reached a low of 1.6% and is currently at a high of 11.8%

Booming economy Credit boom: Investment boom: Asset price boom: Privatisation of the banks completed in 2003 Historically low global interest rates and easy access to cheap foreign-currency borrowing Investment boom: Aluminium smelters and power stations 30% of GDP in 2003 spread over three years Asset price boom: Real house prices up by 128% from 1997 Equity prices up by 550% from Jan. 2003 to July 2007 Consumption boom: Real disposable income rose rapidly Lowering of taxes and explicit promises Wealth effects and easier access to credit

Expansion abroad …

… fuelled by ample global liquidity

Large capital inflows, now a sudden stop

Challenges to monetary policy Large demand shocks, some anticipated Should be business as usual for monetary policy making - why such disappointing results? Too reluctant to raise rates? Credibility issues? Faulty analysis and data? Institutional framework hindering an effective transmission of monetary policy? Insufficient support from the fiscal authorities? Special problems in conducting monetary policy in very small open economies?

Challenges to monetary policy (cont.) Financial accelerator effects: Household, corporate and bank balance sheets have multiplied in size as the commercial banks and firms have expanded abroad and equity and house prices have risen briskly Icelanders took advantage of easy access to foreign credit, leverage increased rapidly and macroeconomic imbalances built up The Icelandic economy was therefore vulnerable when the credit crisis emerged and financial decelerator effects are gaining momentum

Households

Private sector credit

Communication problem ... Limited credibility Illiquid markets Unpredictable monetary policy Large imbalances create large uncertainties regarding prospects

Publication of own policy rate path …

... has had some positive effects …

... but challenges remain

Swap agreements with Nordic banks Lack of access to foreign currency liquidity facilities Swap market failure Depreciation of the króna Swap agreements with three other Nordic central banks announced today Precautionary measure 500 million EUR each Strengthening króna

Final remarks Smallest country in the world with a fully freely floating currency Efficiency costs associated with such a small currency area vs. the benefits of macroeconomic stabilisation due to a shock absorbing role of the exchange rate and independent monetary policy Widely discussed in Iceland at the moment

Final remarks (cont.) Icelandic economy more volatile than most other small open economies and hence attaining an inflation target is more difficult Role of the exchange rate Specially challenging circumstances in the last few years domestically and globally – how representative of the years to come? Lack of credibility of monetary policy make Iceland more vulnerable than e.g. New Zealand Lack of lender of last resort in foreign currency make the commercial banks more vulnerable Monetary policy’s main aim is to restore credibility as soon as possible, today’s measure is a step in that direction