Carry trade-related inflows into the bond market did cause some disruption of monetary policy transmission in summer 2015 and last winter and could have posed risks for financial stability further ahead. For this reason, and also to prevent the development of a new “overhang” following the offshore króna auction in June 2016, it was considered appropriate to take action to mitigate these inflows. Since then, they have largely stopped. However, there has been no let-up in foreign currency inflows in recent months, and by the end of last week, the Central Bank had bought foreign currency in the amount of 160 b.kr. since the beginning of July and the exchange rate had risen by nearly 12% over that same period. The available data indicate that foreign currency inflows are to a large extent related to the trade surplus, which has been quite large, owing partly to growth in tourism and positive terms of trade, plus foreign investors’ increased interest in direct investment in the Icelandic economy. The banks’ and other Icelandic firms’ improved access to foreign credit could play a role as well. On the other hand, speculative  7  flows related to the interest rate differential appear to account for only a small part of the inflows. Another important factor is that liberalisationrelated outflows are still limited. It should be noted, though, that balance of payments figures for Q3/2016 could change the picture somewhat, but they will not be available until the beginning of next month.
This will depend on developments, including exchange rate developments and the stance of other economic policies. In addition, nominal interest rates could change in response to developments in inflation and inflation expectations. Under current conditions, however, it must be borne in mind that the economy is not in balance but in the boom part of the cycle. Furthermore, the contribution from other economic policies is uncertain at the moment because a new Government has yet to be formed after the Parliamentary elections and next year’s fiscal budget proposal has yet to be presented. Moreover, it is too early to say what the impact of capital account liberalisation is. One thing is certain, however: if steep interest rate cuts are made without being warranted by economic conditions, it is clear that the real rate would decline for a while. But because credibility would undoubtedly suffer as a result of poorly grounded measures of this type, it would have to rise again, to a higher level than before, and for a longer period than would otherwise have been needed to bring inflation and inflation expectations back down to target. Is it a lost cause, then, that Iceland’s interest rates might with time become similar to those in trading partner countries? Not at all. First, we must hope, for their sake, that neighbouring countries will not need to  6  maintain such abnormally low interest rates for the long term.