In this context it is important to remember that relatively little development will take place in east Iceland this year and for most of next year. The effect will not begin to be felt to any extent until well into next year and the bulk of construction work will take place in 2005 and 2006. The main conclusion of the Bank’s analysis is that even though this will be the largest construction programme in the history of Iceland, it should be able to go through without disrupting the economy. However, this calls for cautious economic policy implementation. The Central Bank’s analysis shows that with a somewhat stronger exchange rate and higher interest rates than would otherwise have prevailed, and a tighter fiscal stance than would have been needed, inflation will remain inside the tolerance limits of the target, i.e. below 4%, and that this will prevent the economic instability that the construction programme in east Iceland would otherwise have caused. Exchange rate developments and the fiscal input will be major factors in determining how much interest rates will need to rise. However, neither an exchange rate adjustment nor fiscal measures can entirely replace monetary measures, since the change in exchange rate partly reflects expectations of a rise in Central Bank interest rates, beside which the scope of the east Iceland construction programme will simply be too great to be countered solely by cutting back public sector activity.
The policy rate is currently 5.3%. The exchange rate of the króna was fairly stable from last spring and until the winter, then strengthened again towards the end of the year and in the beginning of this year, to reach its highest point for two years. Undoubtedly the expected power-intensive industrial project in east Iceland is a contributing factor. The new monetary policy framework was introduced in a fairly tough climate of a sliding exchange rate and mounting inflation. It is fair to say that the tight monetary stance is the main reason that inflation went back down so quickly. Experience has shown that the monetary policy passed its initial test with flying colours and no one should have any doubts now about the value of monetary policy in the Icelandic economy. It works in Iceland, just as it does everywhere else. On February 10 the Central Bank published its quarterly Monetary Bulletin. As usual, this contains a new inflation forecast along with the Bank’s latest national economic forecast and a new assessment  of economic and monetary developments and prospects. The bulletin also contains an evaluation of the impact of the proposed power-intensive industry and hydropower development projects in east Iceland, which were incorporated into the inflation forecast and national economic forecast. The forecast assumes that inflation will be below the Bank’s target over the next two years. On the basis of this and the new economic forecast, the Governors announced a cut of 0.5 percentage points in the Bank’s policy rate last Monday.