The reason for the repo rate cuts was to alleviate the effects of the financial crisis on the real economy, while ensuring that inflation stabilised around the target of two per cent. Although monetary policy cannot be used to resolve the financial problems, it can help to dampen the negative effects on the real economy, without jeopardising the inflation target. The Riksbank’s assessment is that the financial crisis aggravates the ongoing economic downturn resulting in weaker growth, a deterioration in the labour market and lower inflation. The repo rate therefore needs to be cut by a relatively large amount during a short period of time. In addition to the cuts already made, the assessment at the most recent meeting was that the repo rate needs to be cut by a further 0.50 percentage points, to 3.25 per cent, over the coming six months. The repo rate is currently less effective than normal as a tool for influencing the economy. The repo rate cuts in October did not lead to an immediate fall in interbank rates. The confidence crisis in the financial system has meant that the normal link between market rates and the repo rate has been broken. Although market rates also declined, there remains an unusually large gap between the repo rate and mortgage rates in particular. The gap between the 3-month lending rate to households and the repo rate has been around 100 basis points in less turbulent periods than that we are experiencing now. At present the gap is around 200 basis points.
Although the adjustment would ultimately be greater if it occurred slowly, a very rapid contraction would deliver such a jolt to the finances of many households and businesses that loan losses would result. It is likely that a range of risks will have to be faced, but efforts must be made to minimise the probability of a financial crisis that could harm potential output and living standards. In the final  2  BIS Review 41/2007  analysis, the critical factor is how strong and well equipped the financial system is to withstand shocks, i.e. its resilience. The crucial factor behind the Central Bank’s assessment that the financial system is now more resilient to shocks is the banks’ stronger liquidity and equity positions than a year ago. The major commercial banks have a diversified income base that extends to many countries. Another advantage is the somewhat different business models they have used in their expansion. Their diversified assets give less reason to fear the consequences of an unexpected strain on the financial system. Iceland’s strong fiscal position underpins the banks’ international credit ratings. Other important factors have been the strengthening of Iceland’s foreign reserves and the Central Bank’s capital. Both measures represent natural responses to changes caused in the Central Bank’s operating environment by the very rapid expansion of the commercial banks, especially abroad. Although the main function of a financial stability report is to highlight risks, factors conducive to strengthening the long-term economic outlook should also be duly noted.