When inflationary pressures are looming or building up, the Central Bank raises its policy rate in order to make credit more expensive and reduce investment and consumption, encouraging saving at the same time. The policy rate is not applied to achieve other objectives than the inflation target. Thus it is pointless to set other objectives for monetary policy except by abandoning the objective of price stability, which would be particularly imprudent. Steady enhancements have been made to the conduct of monetary policy. Forecasting has strengthened with a new and much more powerful macroeconomic model. A landmark was reached this year when the Bank began publishing its staff’s projection for the policy rate path that is compatible with attaining the inflation target within an acceptable timeframe. Previous interest rate assumptions had proved unsatisfactory and even misleading. Publication of the policy rate path has been welcomed and has facilitated the Central Bank in exerting the impact that it intends to have on market expectations. International agencies and foreign analysts who monitor economic developments in Iceland have praised the Central Bank’s monetary policy implementation, transparency and professionalism. It is interesting to note that these assessments are at odds with widespread attitudes in Iceland at the moment. In the climate that has prevailed recently, the Central Bank’s policy rate hikes have admittedly affected the exchange rate of the króna first, then demand much later. Among the explanations is that policy rate hikes have not had what should have been their normal effect.
It is perhaps inevitable that as time passes and memories fade, there is less political focus on these issues and less will among jurisdictions to ensure governance keeps pace with the risks. Fatigue sets in. For example:   Before the crisis Basel II, which was not particularly ambitious, took 10 years to agree.   By contrast, post-crisis the key elements of Basel III, which was a significant step-change, took just 2 years.   But as the crisis receded and fatigue developed, it took a further 5 years to finalise Basel 3.1, which implemented less sweeping changes. The lesson fades that in an integrated global economy we are all ultimately in the same boat or in the words of Benjamin Franklin that “if we do not hang together we will most assuredly hang separately”. This had led to fragmentation in the way we implement the reforms we have agreed. Moreover, the circle of players has grown. The governance reform efforts of the last 50 years have been predominantly led by the advanced economies whose financial institutions dominated the global economy. That is changing with the increasing importance in the global economy of emerging markets – indeed much of the financial innovation we see today is happening in the emerging market and developing world rather than in the advanced economies. We are now in short having to work harder to generate the consensus to keep the governance necessary for financial globalisation moving forward in line with the risk. And we can see major challenges emerging.