Iceland’s macroeconomic balance is good, but fragile. On this score, we face three relatively important risks: first, that the interactions between labour market unrest and the turnaround from output slack to a positive output gap could undermine price stability and turn the current account surplus into a deficit; second, that lifting the capital controls could turn out badly, with negative implications for exchange rate stability, inflation, and financial system stability; and third, that the global economic situation could turn against us. Therefore, we must avoid complacency, and we must be vigilant if we are to safeguard our recently achieved stability and face down the three challenges that I have mentioned just now. In some respects, formulating monetary policy is complex at present, as it has been at times in the past. The Central Bank’s interest rates were lowered by 0.75 percentage points in the final two months of 2014, in response to rapidly falling inflation and the decline of inflation expectations to the target. Since then, inflation has dropped still further, falling below 1% in December, triggering the submittal of a report to the Government on inflation below the deviation threshold. Even though inflation is now below 1%, the Central Bank’s key interest rate has been unchanged at 4.5% so far this year. There are a number of reasons for this. First of all, the extremely low inflation rate is due partly to the abrupt drop in global oil and commodity prices in the second half of 2014.
It also explains in part why unemployment among young people is – fortunately – much lower in Iceland than in many of our trading partners. When full employment is achieved, productivity growth will become more important, however. If attempts to ease the tension in the labour market are unsuccessful and wages rise far more than is consistent with the inflation target, it will be unavoidable to respond by tightening the monetary stance; i.e., by raising interest rates. Even if inflation rises early on, the Monetary Policy Committee has the tools it needs to bring it back to target over the medium term. Higher interest rates will have a negative effect on GDP growth and employment over time, however. Real wages and the real exchange rate will rise because of the interactions between rising nominal wages and a tighter monetary stance. In addition, firms would probably respond by slowing down recruitment – perhaps even by cutting back on staff. There is the risk that such a turn of events would be most harmful to labourintensive sectors and workers whose position in the labour market is weakest. It is therefore important to find ways to channel the desire to improve standards of living towards measures  BIS central bankers’ speeches  3  that are likely to generate more lasting results without jeopardising stability and the economic recovery that has brought us this far. Honoured guests: The time for decisive steps towards lifting the capital controls is rapidly approaching. Some may think this step comes rather late.