In the fall and in early winter, the market also felt the weight of rapidly deteriorating global lending terms, which will undeniably support the Central Bank’s tightening measures and will reduce domestic demand and inflationary pressure, as was mentioned in the Board of Governors’ announcement of 14 February. It is possible that there will be a rapid drop in domestic demand as a result of high interest rates and a tightening credit supply. At this point, however, it is impossible to assert that this will be the case. Exactly when it will be possible to lower the policy rate will be determined by economic developments and outlook. Precipitate interest rate reductions would push inflation upward and standards of living downward. The suggestion that it is necessary to lower interest rates in order to control inflation is absurd. Indeed, it is astounding how carelessly many people seem to view inflation. Furthermore, it is appropriate to stress that the Central Bank believes it is impossible to choose between price stability and financial stability. If we were to relax our stance on price  BIS Review 25/2008  1  stability, it would surely undermine the credibility of monetary policy. Inflation – and no less important – inflation expectations would increase drastically, which could lead, in short order, to an upward spiral of prices and wages and falling exchange rate.
On the contrary, forecasts suggest that times will be difficult for the greater part of the  2  Moody’s Investors Service: Special Comment: Iceland’s Aaa Ratings at a Crossroads, January 2008. BIS Review 25/2008  5  year, if not longer. The conditions that reigned in the financial markets for several years, and changed abruptly in mid-2007, were also quite unusual, and it is unlikely that such a period will occur again in the foreseeable future. It can be considered certain that investors will be much more cautious in the future than they were until the middle of last year, and that the banks’ room for manoeuvre will be more limited than it has been for a long time. Icelandic companies, including banks, must therefore adapt to changed circumstances, a tighter credit supply, and less advantageous terms. Under these circumstances, it is even more important to reduce the imbalances in the economy by, among other things, lowering inflation and anchoring inflation expectations. The Central Bank will continue its efforts to that end. 6  BIS Review 25/2008