It could be argued, too, that this is more likely an underestimation than an overestimation, as there is systemic positive bias in household inflation expectations and the breakeven inflation rate in the market entails risk premiums. The effect that the real rate has on domestic demand and inflation depends on what the equilibrium real rate is considered to be at any given time; that is, the real rate that neither stimulates nor dampens the economy. The equilibrium real rate has probably fallen in Iceland, as it has in most economies in the wake of the financial crisis, but exactly where it lies is highly uncertain. One of the Monetary Policy Committee’s tasks is to attempt to assess it. It is normal that Central Bank interest rate should rise above equilibrium when a positive output gap develops and inflation is above target, but neither is the case at present. That being so, it was appropriate to contain the rise in the real rate by lowering the Bank’s nominal interest rates. 2  BIS central bankers’ speeches  Some will surely ask: Shouldn’t the Bank have lowered interest rates earlier? Hasn’t the monetary stance simply been too tight in the recent past? I don’t think this is the right time to dissect these questions, not least because many things look different in the rear-view mirror. As is said in Njáls saga, “Everything is ambiguous in retrospect.” That said, I think there are solid arguments in favour of a negative response to both questions.
In many financial institutions, the rigor of board scrutiny and due diligence was replaced with an over-reliance on external ratings or complex internal models for credit evaluations. This was compounded by incentive structures that were not adequately risk-aligned and inconsistent with long-term value creation, eventually undermining the soundness of banks. These failures have extracted a high price on affected financial institutions, investors and national economies at large. Some of the large financial institutions that entered aggressively into the sub-prime market are now no longer around, while losses from the write-downs of loans and provisions have been staggering. Between the second quarters of 2007 and 2009, the global write-down of loan provisions had amounted to USD1.3 trillion. In October 2009, the International Monetary Fund indicated that the estimates could rise further to as much as USD2.8 trillion 1. The events which have since unfolded underscore the fact that effectively managing risks associated with mortgage financing encompasses a much broader set of considerations – including the consequences of an adverse and broad downturn in the housing market. The crisis has reinforced the need for banks to consider the cyclical developments in the mortgage financing market more explicitly in their risk assessments. Factors such as a sustained growth in house prices, low interest rates and modest equity commitment should inform banks of the risk outlook for the mortgage segment and corresponding risk mitigation actions that are needed to avert potential losses.