A huge number of diligent and eager employees, who still work for shockingly low wages, are streaming into the labour market and producing goods at a far lower price than would be possible in the West. The importation of these goods has counteracted inflationary pressure in Western nations and kept it within the bounds of manageability. But as a result, this newly awakened world gives rise to a growing number of hopeful consumers who lack all of the things we in the West have so long taken for granted, things we couldn’t live without. They are consumers who, for the first time, have money in their hands. These two groups overlap somewhat, of course, but it is clear that the former group has been instrumental in the battle against inflation in the West. It could well be, however, that the latter group will eventually put its weight on the other end of the scale. Globalisation has undeniably eased the battle against inflation, both in Iceland and elsewhere, so it is doubtless inaccurate to assert that globalisation is the reason we are having trouble conquering inflation. Other factors have been much more troublesome, and most of them are home-made. For example, we haven’t managed to contain public investment during an economic upswing – this is eminently clear to anyone who examines figures on public investment, which increased by more than 20% last year and is still growing this year.
This is correct, of course, to a point: the Bank’s policy influences exchange rate developments to a considerable degree, and the exchange rate is higher than Iceland can tolerate for the long term. But the Central Bank’s high policy rate is not the source of the problem. It is a response to the conditions reigning in our economy: strong excess demand no matter where one looks, large output growth, sharp increases in purchasing power, excess demand for labour, influx of capital … the list goes on. The Central Bank decided to raise the policy rate now because inflation has risen once again, and indicators suggest that it will be higher in 2007 and 2008 than earlier projected. Demand has grown more rapidly than was expected when the Bank  2  BIS Review 131/2007  announced its last interest rate decision. Output growth is greater than estimates allowed for. Private consumption is on the upswing, and indicators imply that consumption growth will accelerate even further. Gross capital formation was greater in 2006 and 2007 than previously estimated. Real estate prices continue to rise rapidly, pushing inflation upwards as well. A shortage of labour, wage drift, growing wage costs, and rapidly rising disposable income are also contributing factors. And it appears as though some people think that, under these circumstances, the best solution is to let an inflation episode flow through the economy, as it were. But inflation wouldn’t merely flow through; it would pass into the economy and settle there.