Two factors played leading roles in that development. The first is the relatively large share of foreign-denominated loans – an average of 20% for households and 70% for businesses. The latter factor is an unusually strong exchange rate pass-through effect, which stems from the magnitude of the exchange rate drop and the lack of confidence that the króna would recover in the near future. As a result, the principal of indexed loans – which constitute about 70% of household debt and 10% of business debt – was written up. As is often the case in severe financial crises that are at the same time country crises, there was a genuine risk of a multi-faceted spiral of currency collapse, inflation, debt crisis, and economic contraction. It was critical to stave off such a vicious cycle, and therefore of vital importance to stabilise the exchange rate. BIS Review 146/2009  1  But this was problematic because of the large amount of capital that had accumulated in Iceland through carry trading during the economic upswing. Current estimates indicate that some 500 b.kr. remain in the Icelandic economy. There was the risk that this money would try to escape through a collapsed foreign exchange market, with unimaginable consequences for the exchange rate. Thus it was quite possible that astronomical interest rates would have been required if exchange rate stability were to be achieved through interest rate policy alone.
Chart 6 Wage growth on the rise Wage growth is rising and reached the highest level seen in over a decade last year, turning out higher than we had expected. This can be ascribed in large part to a tight labour market and improved profitability in some business sectors. The social partners expect wage growth to rise further this year, and expectations have increased in recent months. Wage growth is projected to be around 5 percent this year,  2/3  BIS - Central bankers' speeches  which is higher than we projected in December. While wage growth did not keep pace with price growth last year, we expect wage inflation to be slightly higher than price inflation this year. Higher wage growth means higher business costs, which will likely also contribute to sustaining inflation. Figure 7. Further rate rise most likely in May It is our responsibility to ensure that inflation falls to 2 percent. At the same time, we will avoid raising the policy rate beyond that needed to curb inflation. There is considerable uncertainty about future economic developments, but we will most likely raise the policy rate again in May, followed by a further rise to around 3.5 percent in summer. This could mean an increase in the residential mortgage rate to between 4½ and 5 percent. Chart 8 Prospects for lower inflation and somewhat higher unemployment In our current projections, inflation falls back towards 2 percent over the next years.