Mitigating measures would be most effective if they involved both monetary and fiscal restraint, as well as internal adjustment of the national economy, including a rise in the exchange rate. The more restraint shown on the fiscal side, the less need there will be to raise interest rates. A higher króna exchange rate also means less cause to raise interest rates. The exchange rate was fairly stable from the spring of 2002 until early this winter. It then began to rise and continued to do so steadily until early February of this year. The Central Bank has stated its view that the exchange rate rise in recent months has been primarily due to the effect of the proposed major construction projects in East Iceland. The operations of the aluminium smelter will likely cause the equilibrium exchange rate for the króna to be higher than otherwise. Furthermore, it appears evident that the influx of foreign currency in connection with these projects will be considerable, with higher domestic interest rates than otherwise. All of this affects market expectations and makes the króna exchange rate higher than it would be in the absence of plans for major development in East Iceland. The economy could thus be said to have already begun adaptation to the coming projects, i.e. the exchange rate adjustment has begun and is even well on its way.
If inflation looks likely to exceed the Bank’s target limits in a long-term perspective, the Bank will raise its policy interest rate, or cut this rate if inflation is heading below the target limit. In preparing its inflation forecasts and regular assessment of the economic situation and outlook, the Central Bank examines a wide variety of indicators. These include both statistical data and information  BIS Review 12/2003  1  obtained from interviews with representatives of industry, special interest groups, credit institutions and others. Much of this statistical data is available on the Bank’s website. Decisions by the Central Bank’s Board of Governors are made following in-depth examination of these indicators, based on the Bank’s evaluation of the situation and prospects, the premises behind the inflation forecast and the inflation forecast itself. In accordance with the provisions of the Act which entered into force in the spring of 2001, the Board adopted internal rules on the preparation of, arguments for and presentation of its monetary policy decisions. The rules were formally approved at the beginning of 2002 and published in the quarterly Monetary Bulletin. The inflation target adopted in March 2001 removed the earlier fluctuation bands set for the ISK exchange rate and the exchange rate was floated. The new monetary policy framework was introduced under rather difficult conditions, with a sliding exchange rate and mounting inflation. It is fair to say that the tight monetary stance is the main reason that inflation receded as sharply as it did in 2002.