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.
If we do that, then we might profit on the whole arrangement. I expect this spurs questions about whether we need all of the loans that we have negotiated as a part of the IMF programme. In my opinion, this is an eminently justifiable question. First of all, we need the loans in order to ensure that we have sufficient foreign exchange at all times to enable us to pay amortisation and interest on the foreign debt of the Treasury and Treasury-guaranteed entities. As far as the Treasury is concerned, there will be little activity until late in 2011, when a loan of one billion euros, taken in 2006 to reinforce the foreign exchange reserves, will mature. But we can also use the loans to buy the bonds from this series and others offered in the secondary market at low prices, thereby easing the debt service burden and profiting on the whole arrangement. Furthermore, we will need reserves in order to engage in moderate foreign exchange market intervention, with the aim of supporting the króna and reducing volatility. And last – but certainly not least – we need reserves in order to create confidence in the króna and fend off those who would attack it. But such an arsenal, which is only to be used in an emergency, is extremely expensive because it is impossible to invest the reserves at rates comparable to those on the loans themselves without taking an unacceptable amount of risk.