Thus it is important to avoid borrowing more than necessary and to emerge as soon as possible from our current state of imbalance. Before I turn to the economic outlook and the Monetary Policy Committee’s most recent interest rate decision, I consider it necessary to say a few words about the nature of the adjustment the Icelandic economy is currently undergoing. First of all, it should be borne in mind that the year 2009 would have been extremely difficult in any case, no matter whether the banks had collapsed or not. This is because of the huge macroeconomic imbalances that developed in the Icelandic economy in 2005-2007 and had to subside in one way or another. Second, the collapse of the banking system called unavoidably for an additional adjustment in the structure of the economy. We can summarise this as follows: The enormous current account deficit had to go, and the financial system and various other bubble-related operations had become far too large and had to be downsized. This involves considerable unemployment, partly because of layoffs in the sectors that have contracted and the lag time before new commercial activities can be established. Tradable sectors must be reinforced. The key to hastening that process is re-establishing an effective financial system. Although the currency may have played a role in creating the problem, the depreciation is also part of the adjustment, and it is accompanied by transitory inflation.
It would have been tempting to take somewhat greater short-term risk with the exchange rate and direct monetary policy more toward domestic economic conditions and the inflation outlook, but the enormous damage that even a short-lived additional depreciation would have done to private sector balance sheets precluded such an approach. Under conventional circumstances, inflation-targeting monetary policy can be described, albeit in an oversimplified way, as entailing a policy interest rate that takes into account three factors: 1) the desired policy rate when inflation is at target and GDP is at potential; 2) the output gap; and 3) the deviation of inflation from target. In the case of Iceland, the exchange rate must be added to this list, and with a heavy weight. But the weight of the other items is not zero, and the importance of the exchange rate should diminish as the financial crisis relinquishes its grip and we reduce the weight of foreign debt in private sector balance sheets, thereby reducing the impact of the exchange rate on domestic liabilities. One of the Monetary Policy Committee’s many tasks at present is to assess how these various weights should evolve as circumstances change. Indicators presented at the most recent Monetary Policy Committee meeting suggest that foreign-denominated debt may weigh less heavily in corporate sector debt than was previously believed, and that it is currently diminishing in importance for both households and businesses. Before the banks collapsed, an average of 70% of corporate sector debt was denominated in foreign currency. But the distribution is quite skewed.