They will not be solved with miracle cures or ill-advised changes to individual aspects of monetary policy conduct. Monetary policy works. However, it needs support, along with necessary reforms to strengthen its effectiveness. There are no alternatives. But under today’s conditions, where developments in global markets have more direct impact on the Icelandic economy, it is vital for all economic policy measures to have a coordinated focus on restoring macroeconomic stability. This must be the priority. The same principle applies in all countries in a similar position, not least in relatively small and open economies. Relaxing the stance of monetary policy is by no means the answer and it is important not to undermine its credibility. On September 6 this year, the Board of Governors of the Central Bank of Iceland decided to leave the policy interest rate unchanged at 13.3%, as it has been since December 2006. The Board of Governors considered that the short-term inflation outlook had deteriorated somewhat since the previous interest rate decision in July, but long-term prospects were unchanged. Exchange rate developments were highly uncertain and would largely be determined by developments in global financial markets. The Board of Governors concluded its announcement by reiterating its commitment to attaining the inflation target within an acceptable timeframe. The next interest rate decision by the Board of Governors will be announced on November 1, 2007, coinciding with the publication of Monetary Bulletin and the Bank’s new macroeconomic and inflation forecasts. The twelve-month rise in the CPI in September measured 4.2%.
This has complicated the Bank in its efforts to constrain inflation in recent times. One factor has been the changes that took place in the mortgage loan market in autumn 2004 when the commercial and savings banks began competing with the Housing Financing Fund (HFF). The Central Bank’s policy rate hikes impact the interest rates of non-indexed lending by commercial banks and savings banks and the non-indexed end of the domestic bond market. However, for a long time they had little impact on long-term interest rates. Some critics cite this as proof that the Central Bank of Iceland’s measures do not have the same effect as those of other central banks. Yet the development in Iceland is by no means an isolated occurrence. The US experience offers an immediate example. The Federal Reserve began raising its federal funds rate early in 2005 in progressive steps until early this year, from 1% to 5.25%. These hikes had no effect on long-term interest rates in the US, which have been broadly steady since 2005 apart with only minor fluctuations in either direction. US monetary authorities were puzzled by this development. I cite this example because it has been claimed that, unlike the Central Bank of Iceland’s decisions, the impact of changes in the Federal Reserve’s rates is immediately transmitted in full to long-term interest rates.