How do we reduce inflation?

By making the use of money for purchases and investments more expensive and, at the same time, making it more advantageous to save. This is achieved by raising interest rates, which are essentially the price for using money. Raising interest rates should reduce demand for goods and services and at the same time reduce inflation. The Central Bank’s interest rates are therefore the bank’s main policy tool for achieving the inflation target of 2½%. This refers to the bank’s interest rates in transactions with other financial institutions, which then affect other interest rates in Iceland. Commercial banks and pension funds regularly change their interest rates in response to changes in the Central Bank’s key policy rate. If interest rates are raised, it becomes more expensive to borrow and more profitable to save, and vice versa if interest rates are lowered. Monetary policy thus affects the saving and spending decisions of households, businesses, and the public sector, which ultimately affects prices. If people buy less and save more, there is less incentive to raise prices and vice versa. Should the Central Bank deem it necessary, it can also conduct transactions in the interbank foreign exchange market with a view to influence the exchange rate of the króna and thereby affecting the price level.

We call it the transmission mechanism of monetary policy when the Central Bank's interest rate decisions affect other interest rates, demand, and ultimately inflation. An important part of the transmission mechanism of monetary policy takes place through the credit system. The interest rates offered to credit institutions by the Central Bank determine the extent to which credit institutions can offer individuals and businesses favourable rates. Higher lending rates, all else being equal, reduce credit demand. They can also reduce the supply of credit as credit risk may increase, for example, because the net assets of households decrease, the market value of companies decreases, and their cash flow deteriorates.

Another transmission mechanism of monetary policy is through the exchange rate of the króna. If interest rates on domestic securities are higher than on comparable foreign ones, it becomes more attractive to hold domestic securities, provided the exchange rate of the króna remains stable. By increasing the interest rate spread between domestic and foreign assets, the Central Bank can encourage capital inflow or reduce outflow, i.e., spur demand for the króna. Under normal conditions a rise in interest rates prompts an exchange rate appreciation, contributing towards lower import prices which, all things being equal, has a direct effect on reducing inflation. Since changes in the exchange rate alter the relative prices of domestic and foreign goods and services, and thereby the competitive position of domestic companies vis-à-vis foreign ones, they also exert an effect on external trade and domestic demand. An appreciation makes imported goods and services relatively cheaper, channelling demand out of the domestic economy. Demand for domestic production contracts, which all else equal should also lead to lower inflation.

Central Bank policy rates also have an effect on asset prices, e.g. equity prices and housing prices, and therefore on the net assets of households and businesses. Normally, a rise in the policy rate brings down equity prices: This is primarily because the expected payment flow from the shares will, all else being equal, be worth less today if interest rates rise. Secondly it is because demand for bonds grows at the expense of equities when bond yields rise and less demand for equities can lead to a drop in their prices. Thirdly, because higher interest rates may cause an increase in the financing costs of businesses, thereby reducing their profits, out of which dividends to shareholders are paid. Similarly, interest costs on mortgages rise, dampening the demand for housing and easing upward price pressures in the housing market. Declining equity and housing prices reduce the wealth of individuals, which in turn reduces their propensity and ability to spend. A decline in share prices also reduces the market value of companies, making it relatively less favourable to issue new equity to finance new investments.

Finally, monetary policy has an impact on the public's expectations regarding future developments such as, for example, economic growth and inflation and the uncertainty related to these expectations. Changes in expectations affect the behaviour of financial market participants and elsewhere in the economy, including individuals' expectations about their employment prospects and the expectations of businesses on future sales and profits. A rise in the policy rate may be interpreted as signalling that the Central Bank identifies the need to cool the economy in order to achieve its inflation target. Thus growth prospects decline in the wake of an interest rate rise, but the likelihood of price stability improves. If the measure is credible it should cut back inflation expectations and support the Bank's effort to maintain stable prices.

International research suggests that the impact of monetary policy actions on domestic demand is generally first felt after roughly six months and that it has largely been transmitted after one year. The impact on domestic inflation generally begins to be felt after around a year and has largely been delivered between 1½-2 years after the rate increase. The transmission mechanism in Iceland is broadly described in the handbook for the Bank’s quarterly macroeconomic model (QMM).

It should be emphasised, however, that the transmission mechanism may vary from one period to another, and considerable uncertainty surrounds it, both in terms of the ultimate scale of the impact and the lag between changes in Central Bank policy rates and their effect on the economy. It is likely that the effectiveness of monetary policy largely depends on its impact on expectations and sentiment. It is therefore imperative to strengthen such trust by implementing monetary policy in a transparent and credible manner.