This was compounded by unforeseen changes in the credit market when banks began offering mortgage loans in competition with the state-owned Housing Financing Fund [HFF], after the latter announced a substantial increase in its loan-to-value ratio and mortgage amounts. Another unexpected event was the issue of króna denominated Eurobonds [glacier bonds], one sideeffect of which was to delay the transmission of the Central Bank’s policy rate hikes across the domestic yield curve. The background to these transactions is a global glut of savings which has led to exceptionally low international interest rates, coinciding with unusually high interest rates in Iceland. One consequence was to divert much of the monetary policy impact into the exchange rate channel. 1  The press release is posted on the Central Bank’s website, www.sedlabank.is  BIS Review 16/2007  1  Another more positive consequence was a surge in turnover in the domestic financial markets, which deepened them by bolstering price formation and enabled them to handle much larger trading volume smoothly, without significant price volatility. Policy rate changes are only passed through in full to domestic demand with a sizeable lag. In a small, open economy like Iceland, the impact is initially reflected in the exchange rate. Other things being equal, a rise in the policy rate causes a temporary appreciation of the króna, which squeezes the export and traded goods sectors and also channels demand out of the economy. The banks’ surprise entrance into the domestic mortgage market made it difficult for the Central Bank to respond effectively.
If given enough authority, rules can induce symmetric behaviour. It remains to be seen how the discretionary fiscal measures adopted in response to the crisis can be wound down and reversed to support fiscal sustainability in the longer run. Since the ECB has started to gradually phase out its extraordinary liquidity support measures, fiscal authorities should also start to withdraw stimulus to safeguard public solvency over the medium term. To support this, we have the right mechanisms in place in Europe. Governments will have to comply with and, as experience shows, even re-enforce the fiscal rules enshrined in the Stability and Growth Pact. Concluding remarks: some lessons From this quick overview, I draw two lessons for monetary policy. The first lesson to be learned is that central banks need to broaden – not restrict – their overview of the economy. Monetary data are critical in warning against risks that are slow to appear in inflation forecasts. Monetary analysis at the ECB consistently sent early signals that risk was broadly under-priced, when inflation was quiescent and measures of slack were moderate. BIS Review 22/2010  3  The second lesson is that price stability is the only anchor which can pin down the economy in turbulent times. It is not sufficient to guarantee financial stability, but it is certainly necessary to prevent financial instability. Increasing the level of inflation that central banks should aim at would be a step in the wrong direction.