One reason for Iceland’s limited success in keeping inflation in check has been precisely that the impact of the Central Bank’s policy rate hikes has not been transmitted in full to the mortgage loan market. In particular this is because one of the players there, the HFF, enjoys Treasury guarantees on its borrowing, enabling it to meet its funding requirement by issuing bonds at very long maturities with lower yields than on shorter issues, so that it can avoid raising interest rates on its new lending, which under normal circumstances would have been warranted and called for by the Central Bank’s monetary stance. Since autumn 2005, market yields on indexed bonds have risen in the range ½ to 2 percentage points, depending upon the issues involved. At the same time, HFF interest rates have gone up by half a percentage point. So it cannot be said that Iceland faces the same conundrum as the US about why long-term interest rates have not risen in the wake of policy hikes. House prices began to increase significantly again last spring, in the teeth of general expectations, and have been the main driver of the CPI in recent months. It is not unlikely that the latest wave of price rises in the housing market is at least partly due to decisions by  2  BIS Review 111/2007  the government and HFF last winter to raise the loan-to-value ratio and mortgage ceilings and to lower interest rates on new lending.
Even though neither the changes nor amounts involved were large, there is little doubt that they had some effect and prompted a new marketing drive by the banks. In a climate of rapidly growing disposable income, house prices began to soar again. The Central Bank has emphasised the need to change the public sector mortgage credit system but has not stated an official view as to how this should be done. Nonetheless, immediate reforms are vital to give monetary policy more leverage over the mortgage loan market. Another important consideration is that whatever mortgage loan arrangements that are developed should provide a solid foundation for the domestic bond market. The Central Bank has been making these points for several years with little result. International agencies have agreed that a review of the role of the HFF is long overdue. Particular mention may be made of the IMF, most recently this summer. The Fund’s reports show that its analysts have striven to make an in-depth study of mortgage credit arrangements in Iceland. In its Article IV Consultation report published in June, the IMF claimed that a higher policy rate than otherwise had been needed as a result of the HFF’s activities. It should be added that one reason for the limited success in keeping the lid on inflation has been an enormous increase in disposable income in 2006 and 2007, driven by both wage rises and tax cuts. These factors and others have fuelled domestic demand and thereby inflationary pressures.