We must not forget, either, that financial crises of the magnitude of the one in Iceland cast long shadows, and many have faced hardship for a long time afterwards. This underscores the necessity of safeguarding financial stability. The Central Bank’s contribution to this successful outcome is threefold: formulation and implementation of monetary policy; participation in the resurrection of the financial system and the formulation and implementation of financial stability policy; and participation in the development of the capital account liberalisation strategy and the execution of the strategy. I will now turn to these three factors and, as I do so, move to the present day. Inflation subsided in 2009 and 2010 as the inflationary impact of the steep drop in the exchange rate in 2008 tapered off and the exchange rate stabilised in H2/2009 and then began to rise in 2010. Inflation declined steadily until it fell to target in late 2010. As inflation eased, Central Bank interest rates were cut, reaching a low of 3½% early in 2011. Inflation expectations remained above the target, however. In H2/2011 and 2012, inflation rose again following the depreciation of the króna and large contractual wage increases. We know now that monetary policy achieved good results in its response to this situation. The response consisted of interest rate hikes and signalling of further ones to come, but also of more active use of other policy instruments such as foreign exchange market intervention and, later, the special reserve requirement on capital inflows into the bond market and high-yielding deposits.
The second review of the economic programme with the IMF, and the disbursement of the second tranche of the loan facility, was delayed because of the Icesave dispute. The capital controls had sequestered an overhang of offshore krónur amounting to some 40% of GDP, and it was not yet known how big a balance of payments problem lurked in the failed banks’ estates, as the split between the new and old banks had not been completed. The new banks had not yet been capitalised sufficiently, and non-performing loans represented a major problem. As a result, it was highly uncertain how the new banks would fare. Would efforts to put public sector finances on a sustainable footing be successful? In short, all three of the key objectives of the IMF programme were still up in the air: exchange rate stability, fiscal sustainability, and financial system reconstruction. We know now that the turnaround was just around the corner. The economic contraction, of course, was a consequence of the financial crisis, but it also stemmed from the inevitable adjustment of unsustainable economic imbalances and from the contraction of bloated sectors such as construction and financial services. The adjustment showed most clearly in the current account balance, which flipped from a double-digit deficit before the crisis to a sizeable surplus as early as 2009. Such a swift and sizeable turnaround is a rarity in international context and has drawn considerable attention.