Már Guðmundsson: Currency and exchange rate regime options Introduction by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, to a report issued by the Central Bank of Iceland on Iceland’s currency and exchange rate policy options, Reykjavík, 7 September 2012. * 1.1  *  *  Introduction  In the near future, Icelanders must make important decisions concerning the framework for the currency and monetary policy, the structure of the financial system, and the degree of integration with the world economy. These decisions must be taken in view of what can be learnt from the financial crisis and from previous monetary policy implementation in Iceland. Iceland has applied for membership of the European Union (EU) and, if membership materialises, it will define a clear path for most of these issues. If Iceland does not join the EU, the choices will be different. In both instances, Iceland must lift the capital controls that are currently in place. According to EU rules, this must be accomplished before accession. The experience of recent decades shows, however, that completely free movement of capital comes with significant risk. To reduce that risk, it is necessary to develop a regulatory framework that prepares the Icelandic financial system for the volatility that can accompany free movement of capital. That regulatory framework may entail some restrictions on Iceland’s financial integration with other countries, particularly as regards domestic financial institutions’ freedom to conduct international business. The scope of such restrictions will depend, however, on which currency option Iceland chooses.
Meanwhile, in Europe, which is heavily dependent on Russia for energy, rising prices of oil and natural gas are the biggest concern. And in the Middle East, there are fears of a wheat shortage, given the region's reliance on wheat from Russia and Ukraine. The one bright spot regarding inflation is that longer-run inflation expectations remain well anchored. This anchoring is seen in both market-based measures of expected inflation and in surveys of households and economists. For example, the New York Fed's Survey of Consumer Expectations has fielded special survey questions on fiveyear-ahead inflation expectations since 2019, and these expectations have hardly budged since the start of the pandemic.2 In addition, the pass-through of inflation surprises to revisions in three-year-ahead inflation expectations is about half as large as it was before 2020. 3 That is, medium-term inflation expectations in this survey are less responsive to inflation shocks than they were before the pandemic. Economic Outlook Faced with rising inflation but otherwise strong economies, the Federal Reserve and other central banks have been moving away from the extraordinarily accommodative stances they took in early 2020. Last year, many emerging market central banks raised their policy rates. In December, the Bank of England followed suit, followed by the Bank of Canada this March. Closer to home, the FOMC decided a little over two weeks ago to raise the target range for the federal funds rate by a quarter of a percentage point.