Interest rates The main objective of the Central Bank of Iceland, like those in many other countries around the world, is to promote price stability. An intermediate objective has been to secure the value of the króna. To do so, the Bank applies its policy rates, namely the rates of interest that it sets for its transactions with credit institutions. In a scenario of overheating and inflationary risks, the Central Bank raises its interest rates, as it has been doing in recent times. The Bank already took such action in the second half of 1997 and raised interest rates fairly rapidly in 1999 and 2000. Over these two years, the Central Bank raised its interest rates seven times in all, by a total of 3.6 percentage points. The policy rate is now 11.4%, which is very high by international comparison. However, under certain circumstances interest rates have been this high or even higher in various other industrialised countries. Broadly speaking, these interest rate rises served a double purpose. Firstly, they were aimed at influencing the exchange rate differential with abroad, thereby exerting a direct impact on capital inflows and supporting the exchange rate of the króna. The other purpose was to contribute towards higher interest rates at credit institutions and thereby reduce the expansion in their lending. Experience shows that the impact on lending will emerge eventually. All these measures were aimed at reducing consumption and investment.
And market valuations collapse. In short, finance magnifies the cycle. This is detrimental to you, to lenders, and to the rest of the economy. And to your great credit, your industry has been in the vanguard of thinking to deal with this. The proposal of the cross-industry Vision for Real Estate Finance, led by Nick Scarles of Grosvenor, was that everyone – lenders, borrowers and regulators – should consider appropriate levels of debt not relative to market prices but relative to cash flows capitalised at long-term, cycle-neutral, rates. Put simply, if prices rise because of sentiment rather than cashflow prospects, that should result in greater reliance on equity, rather than debt, finance. So when the inevitable reverse in sentiment happens, it won’t be magnified by an overindebted industry. The industry proposal is music to our ears. If you apply it, it will stop debt running away unsustainably in the good times. And it will cushion the bad times. It’s countercyclical, mirroring the way capital requirements for banks will now operate. And it’s completely in tune with the broader aim of reducing the way finance magnifies cycles. So we want to help you make progress with it. As capitalisation rates come down from their post-crisis highs, the need to do so is increasing. BIS central bankers’ speeches  3  So in a matter of months, the Bank of England will start reporting market-wide indicators of valuations and gearing based on cashflows capitalised at cycle-neutral rates. It will help you to measure the risks.