If inflation looks likely to exceed the Bank’s target limits in a long-term perspective, the Bank will raise its policy interest rate, or cut this rate if inflation is heading below the target limit. In preparing its inflation forecasts and regular assessment of the economic situation and outlook, the Central Bank examines a wide variety of indicators. These include both statistical data and information  BIS Review 12/2003  1  obtained from interviews with representatives of industry, special interest groups, credit institutions and others. Much of this statistical data is available on the Bank’s website. Decisions by the Central Bank’s Board of Governors are made following in-depth examination of these indicators, based on the Bank’s evaluation of the situation and prospects, the premises behind the inflation forecast and the inflation forecast itself. In accordance with the provisions of the Act which entered into force in the spring of 2001, the Board adopted internal rules on the preparation of, arguments for and presentation of its monetary policy decisions. The rules were formally approved at the beginning of 2002 and published in the quarterly Monetary Bulletin. The inflation target adopted in March 2001 removed the earlier fluctuation bands set for the ISK exchange rate and the exchange rate was floated. The new monetary policy framework was introduced under rather difficult conditions, with a sliding exchange rate and mounting inflation. It is fair to say that the tight monetary stance is the main reason that inflation receded as sharply as it did in 2002.
After the introduction of inflation targeting in 2001, the Central Bank has no specific objective as far as the exchange rate is concerned. This is in accordance with its policy of targeting inflation and a floating exchange rate. This has been interpreted to mean that the Bank is completely disinterested in developments in the exchange rate. This is not true. The exchange rate for the króna is very important, the events of the past year or two are more than sufficient indication of that. As the Bank has previously pointed out, the real exchange rate at present is not far from average over the past 20 years, nor much above the average of the past 10 years. The nominal exchange rate since the beginning of this year is in fact slightly lower than it was during the same months two years ago. The exchange rate for the króna is determined by the situation and strength of the national economy, external equilibrium and market expectations. The present exchange rate thus reflects to a considerable extent factors which the Central Bank can do little to influence. The large exchange rate fluctuation from 2000 to 2002 can be attributed to specific circumstances, and the exchange rate is unlikely to fluctuate as substantially in the immediate future as it did during this period. It should be borne in mind, however, that the nature of the Icelandic economy and its small size does mean that currency fluctuations as a rule will be greater than between the currencies of larger economies.