1. 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
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.

2. Damaging effects of the crisis …

3. … due to lack of confidence …

4. ... reflecting domestic vulnerabilities

5. Sharp turnaround underway

6. 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

7. 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

8. 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

9. 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

10. ... but expectations remain unanchored

11. 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%

12. 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 to July 2007
Consumption boom:
Real disposable income rose rapidly
Lowering of taxes and explicit promises
Wealth effects and easier access to credit

13. Expansion abroad …

14. … fuelled by ample global liquidity

15. Large capital inflows, now a sudden stop

16. 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?

17. 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

18. Households

19. Private sector credit

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

21. Publication of own policy rate path …

22. ... has had some positive effects …

23. ... but challenges remain

24. 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

25. 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

26. 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