In addition, the experience of recent years, most recently from Asia shows that it has become more difficult to maintain a stable exchange rate with the liberalization of capital movements and ever larger and more active international financial markets. A response to this would be to allow the exchange rate to float, but in order to maintain low inflation and achieve narrower interest differential vis-à-vis abroad this would call for the adoption of a direct inflation target with the Central Bank entrusted to pursue it. A unilateral link to the euro is hardly an option, as it would yield little in terms of greater credibility of stability and narrower interest differential vis-à-vis those abroad. In addition it has the drawback of not reflecting the composition of Iceland’s external trade, at least for as long as the United Kingdom remains outside the monetary union. A bilateral link would be better, as it would enhance credibility by virtue of the commitment of the European Central Bank to defend the link, and would result in narrower interest rate differentials. The exchange rate risk premium would not vanish entirely because the commitment of the European Central Bank would never be without limits and conditions. It should be pointed out that it is unclear if and when the European Central Bank will be willing to discuss the possibility of bilateral co-operation with countries outside the union. Exchange rate changes could still take place in the case of a bilateral link with the euro.
Our inflation forecast for mid-2011 is 5.4 percent. We expect non-food inflation to be lower than these figures. Figure 14: Inflation Forecasts* Forecast Range*  Output Gap  Uncertainty Band for 2008  End-Year Inflation Targets  12  Control Horizon  10 8 Percent  6 4 2 0 -2 -4 2011-II  2011-I  2010-  2010-III  2010-II  2010-I  2009-  2009-III  2009-II  2009-I  2008-  2008-III  2008-II  2008-I  -6  Source: CBT * The shaded region indicates the 70 percent confidence interval for the forecast. To sum up, although economic activity in the past quarter have evolved in line with our expectations, the significant increases in oil and processed food prices have led to an upward revision in our forecasts. The main message of the forecast is that preventing the materialization of potential second round effects and ensuring a steady decline in inflation towards the medium term targets, requires the monetary policy to maintain a cautious stance for a while. BIS Review 100/2008  11  Therefore, the path for the policy rates indicated above should not be perceived as a commitment on behalf of the CBT. I would like to once more emphasize that any new data or information regarding the inflation outlook may lead to a change in our policy stance. 4.