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.
The Central Bank of Iceland has partly performed this task through its Bank Inspectorate which has been built from the ground up in the Bank and is closely linked to some of the Bank’s other activities, for example in regard to a joint database. Parliament is currently debating draft legislation, which calls for the creation of a new supervisory institution, which would combine all supervision of financial institutions. I cannot deny that the Central Bank is opposed to these ideas for reasons I discussed at this venue last year, and I shall not go into the issue in any more detail now. However, since the government’s wishes in this matter became clear the Central Bank has co-operated wholeheartedly with the Ministry of Commerce in preparing the best possible legislation in this area and in securing the necessary link between the Central Bank and the new supervisory institution and also to ensure that The Central Bank will have all necessary opportunities to guard a sound and effective financial system. In some central banks, which do not have supervision among their responsibilities, such as in Sweden and the United Kingdom, much work has been put into defining the relevant tasks of the central bank. The Central Bank is bound to seek models in these countries when it becomes clear that the Bank Inspectorate will depart.