To cut a long story short, it was decided to introduce a new monetary framework in March 2001. An inflation target was set for the Central Bank and the króna was floated. By that time it had already fallen to the lower tolerance limit. The króna then depreciated further, driving up inflation which rose beyond 9% in January 2002. A rapid reduction in inflation followed, the target was attained by the end of the year and the policy interest rate was quickly lowered. Inflation remained below or close to target until the middle of 2004. Later that year, major investments were decided in the aluminium and power sectors. Shortly afterwards, sweeping structural changes in the housing mortgage market caused a surge in bank lending and domestic demand. The current account also deteriorated significantly. In the face of mounting inflationary pressures, the Central Bank steadily raised its policy rate (undiscounted yield) from 5.3% in spring 2004 to 14.25% at the end of last year, where it still remains. Higher interest rates caused the króna to appreciate and it ended up at a historical high, especially in late 2005. Following earlier comments to that effect in its Monetary Bulletin in December 2005, the Central Bank pointed out that the króna was at its strongest in real terms since 1988. One assumption in the inflation report presented then was that the exchange rate would remain unchanged over the forecast horizon. The Bank described this assumption as unlikely to hold.
The Bank’s capital was also boosted. The main rationale for increasing the reserves and capital was to strengthen the Bank in performing its functions in a much expanded financial sector, and to address comments from rating agencies and others about the Bank’s inadequate foreign liquidity relative to Iceland’s large foreign debts, which are overwhelmingly in the private sector. There was no other motive behind boosting the reserves and the Central Bank has underlined the importance of not creating moral hazard. Unease in the markets lasted until mid-2006, when it calmed down significantly. By then, the króna had depreciated by one-quarter and around mid-year the real exchange rate was close to the twentyfive-year average. In historical terms it was much more normal than in the second half of 2005, i.e. before the depreciation in the first half of last year. This is an important fact to bear in mind, i.e. that the króna depreciated from an unsustainable and far higher real exchange rate than was compatible with external balance of the economy. The change was actually normal and necessary, and formed part of the pressing external adjustment of the economy. Since the middle of last year, the króna has been fairly stable. It has fluctuated within a relatively narrow corridor which it has only moved beyond in a few exceptional cases. So far this year it has strengthened. Since the beginning of 2007 the nominal exchange rate has on average been 14% weaker than the average for the last quarter of 2005.