But transmission through the exchange rate channel is uncertain and volatile, as the exchange rate is also an asset price that fluctuates with speculative capital flows and can deviate from equilibrium over time, only to correct quite suddenly. Unless the financial system is even better protected, this process can interact very badly with financial stability, as was the case in Iceland during the financial crisis. In its publications “Monetary policy in Iceland after capital controls” and “Prudential rules following capital controls”,2 the Central Bank has described the framework that it considers appropriate to replace the pre-crisis framework. Much of what is described in the two reports has already been put in place, but the final brushstrokes remain undone. We intervene in the foreign exchange market; i.e., we have a managed float and not a free-floating currency. We have adopted prudential rules that greatly reduce the banks’ opportunities to take risks with their foreign currency balance sheets. We have established a Financial Stability Council and a Systemic Risk Committee in order to monitor financial system risk more effectively than we did previously, and we are developing prudential rules and macroprudential tools to respond to systemic risk. This will make the conduct of monetary policy easier. And in addition, I hope that statutory amendments will be passed soon in order to put brakes on foreign-denominated lending to resident borrowers without foreign currency income and assets.
Már Guðmundsson: Monetary policy at a crossroads Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at the Icelandic Chamber of Commerce Monetary Policy meeting, Reykjavík, 5 November 2015. *  *  *  Honoured chairman, ladies and gentlemen: The Iceland Chamber of Commerce has a decades-long tradition of holding a meeting like this one on economic developments and prospects and monetary policy. The meeting is held following the publication of the Central Bank’s autumn forecast and, in latter years, the Monetary Policy Committee’s interest rate decision. The title of my talk today is Monetary policy at a crossroads. These crossroads are, first, the disappearance of the slack in the economy and the development of a positive output gap, with the result that the task of monetary policy is no longer to stimulate GDP growth to the extent that the inflation target allows but to ensure that the tension in the economy does not cause overheating, which would jeopardise economic stability. The second crossroads is that, in recent months, the labour market situation has become much more serious than would have been anticipated given the state of the economy. The third lies in the unusual level of uncertainty about the inflation outlook, stemming from the interplay between domestic inflationary pressures and the global tendency towards deflation. And fourth is the recent rapid progress in solving the of the balance of payments problem Iceland has faced since the financial crisis struck and the approaching liberalisation of capital controls.