It’s a world that presents us with enormous new possibilities, but also enormous new challenges.” 2 In my presentation here today I will, not surprisingly, take a central banker’s view and ponder the challenges this new world might raise for a central bank trying to achieve both financial and nominal stability. Financial stability The last decade or so, we have witnessed increased financial integration and competition across national borders. The unleashing of international competition in financial markets is a positive development. By spreading and diversifying risk, financial markets have become more efficient and stable. Deeper and more mature markets tend to be better equipped to deal with uncertainty and distress. We have also witnessed the forging of new and ever more complex financial instruments. Increasing the set of available financial instruments creates more complete markets. It enhances the opportunities for households and enterprises to decouple consumption and investment from current income. Investors can take on or load off risks in a more tailored fashion than before and actively manage their exposures and relocate risks to those best equipped to bear them. Yet, the flip side of increased financial integration and diversification is the potential for more widespread contagion if something goes wrong. Furthermore, rapid innovation and increased complexity can make it difficult to assess the real underlying risks of the new instruments. It takes time for borrowers and lenders to learn the true characteristics of new instruments.
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.