Apart from a short period early in this decade, when Iceland was at an entirely different point in the business cycle than it is now, the Central Bank’s interest rates are at their lowest since the early 1990s, when they became an important monetary policy instrument. We must therefore consider realistically whether we can expect further reduction of interest rates without an outright slack in the economy. Developments in Central Bank rates over the coming term will be determined by economic developments, which could be in either direction. When we met a year ago for the Bank’s Annual Meeting, the vast majority of the capital controls had just been lifted. As expected, exchange rate volatility increased afterwards. But that volatility proved temporary, and short-term fluctuations in the exchange rate subsided markedly in the latter half of the year. In recent months, short-term volatility has actually been limited in historical and international context. The Central Bank has not intervened in the foreign exchange market in recent months, supporting the conclusion that this reduced volatility is due to improved balance in capital flows. According to currently available forecasts, GDP growth is set to remain robust and the domestic economy will experience a “soft” landing. The outlook is uncertain, however, and various risks could materialise, not only in Iceland but also abroad, where uncertainty is considerable at present. In addition, it is important that there is considerable scope for interest rates and large foreign exchange reserves to respond to adverse developments.
One of the main reasons for reduced demand pressures in the economy is that GDP growth has subsided after peaking in 2016 and is now approaching its longterm trend rate. The slowdown in GDP growth reflects weaker export growth, as the tourism boom cannot be expected to continue at the pace seen in the recent past. Furthermore, the improvement in terms of trade has slowed down considerably. This means that the effects of the positive shocks that enabled us to grow rapidly and simultaneously keep inflation low are tapering off. The appreciation of the króna played a major role in the economy’s adjustment to these shocks. However, the Bank intervened in the foreign exchange market and imposed a special reserve requirement (SRR) on capital inflows to prevent the  Thórarinn G. Pétursson (2018), „Disinflation and improved anchoring of long-term inflation expectations: The Icelandic experience“, Central Bank of Iceland Working Paper no. 77. This improved performance of monetary policy is also discussed in detail in Central Bank Special Publication no. 11, entitled “Monetary policy based on inflation targeting: experience since 2001 and post-crisis changes”. See: www.sedlabanki.is 1  1  króna from overshooting. Now, however, a significant additional rise in the real exchange rate would be risky. Interest rates in Iceland are currently low in historical context, particularly in view of the business cycle position. With one short-lived exception, indexed Treasury bond rates have never been lower, and indexed mortgage lending rates are also at a historical low.