23 May 2008

Board of Governors' Press Conference Thursday May 22, 2008 - The Bank's assessment and an abbreviated translation of the main questions and answers

First the assessment, presented by Mr. David Oddsson, Chairman of the Board of Governors:

Monetary policy statement by the Board of Governors of the Central Bank of Iceland: Policy rate left unchanged

The Board of Governors of the Central Bank of Iceland has decided to leave the Bank's policy interest rate unchanged at 15.5%.

In the wake of the depreciation of the króna during the first three months of 2008, the Bank raised the policy rate by 1.75 percentage points in two increments, first in late March and then in early April. As could be expected, the fall in the exchange rate pressed inflation upwards in April, and in the months to come, inflation could rise still further than the Bank projected in its April forecast. Increased domestic costs due to the exchange rate depreciation, wage increases, and price hikes abroad will shape near-term developments to a large extent. Ultimately, however, the effects of a narrowing output gap and declining demand will dominate, and inflationary pressures will subside.

According to the Central Bank's forecast, published in the April 2008 issue of Monetary Bulletin, domestic demand will contract markedly in the next couple of years, and the housing market will cool off. While signs of the latter have been crystallising since early April, it is now apparent that demand growth is waning as well. However, there are still no clear indications of a slowdown in the labour market.

It is of paramount importance that a short-term burst of inflation not be allowed to generate a spiral of rising wages and prices and a falling króna. A high policy rate and other measures taken by the Central Bank and other authorities – including increased issuance of Government securities – are intended to foster stability in the foreign exchange market, which is an important precondition for controlling inflation and inflation expectations. The currency swap agreements between the Central Bank of Iceland and the central banks in Denmark, Norway, and Sweden had a positive effect on the market, but they do not cure all ills.

It will not be possible to relax the monetary stance until it has been demonstrated that inflation is on the wane, as few things are more important for the balance sheets of households and businesses than that disinflation begin and continue on a firm path. The Board of Governors will continue to make its policy rate decisions based on this fundamental consideration.

An abbreviated translation of the main questions and answers:

May 22, 2008


Central Bank of Iceland:


Board of Governors’ press conference, Thursday, May 22, 2008



Question: If the Bank envisages higher inflation than was forecast in April, is it a sign of a change of strategy that you aren’t raising the policy rate now?


Chairman of the Board of Governors: No. Short-term inflation may be higher, but as we stated, the Bank believes the restraint inherent in the current policy rate will suffice. We believe that inflation will ultimately yield under the pressure of the Bank’s actions and other changes that have taken place. The fact that short-term inflation is or may become slightly higher than was projected in April doesn’t justify our raising the policy rate at this time.


Question: How long does the Central Bank believe businesses in Iceland can tolerate these high interest rates?


Chairman of the Board of Governors: It is abundantly clear that this high interest rate is not a pleasant thing for anyone in need of market funding, but it is the only tool that we in this Bank have in order to unwind the significant inflationary pressure in the economy, and we must use it. Various other tools can be used as well, but it is in other people’s hands to ensure that they are also used. But to answer directly, we expect that when the economy slows down, interest rates can begin to taper off, and the downward cycle can take place in an orderly manner when that time comes.


Question: If this is a short-term spurt of inflation, when does the Bank think inflation will begin to subside?


Chairman of the Board of Governors: We have been expecting to see some change at the end of this year and the beginning of next year.


Question: At the moment, inflation is the highest it’s been since sometime in the 1970s or 1980s. New inflation figures are to be released next week and it looks as though it will be not far from 2%. In view of this, why have you not raised the policy rate?


Chairman of the Board of Governors: As I said before, we view the Bank’s interest rate decisions as a long-term strategy that is not affected by temporary fluctuations. As has been said previously, the long-term results have to emerge before it is possible to see whether the strategy has been successful. But in our estimation, the current level of restraint should ensure that the Bank’s objectives are achieved.


Question: Can we expect the policy rate to be lowered, perhaps, on the next decision date?


Chairman of the Board of Governors: It would be unwise to expect that.


Question: What about the work on strengthening the foreign reserves? These credit lines were announced the other day; can we expect that other banks will join the group? 


Chairman of the Board of Governors: Recently we announced agreements with three specific central banks, and at that time we said we would not make any further announcements unless we had something concrete to make an announcement about. I think that’s a wiser course than engaging in advance speculation.


Question: It has been said that a fall in the exchange rate like the current one should have been foreseeable; that it happened in 2001 and then in 2006, and the banks took defensive action in 2006. Should the Government have done the same?


Chairman of the Board of Governors: In its publications, the Central Bank has said repeatedly that the exchange rate was likely to fall after remaining so high for so long. The Bank’s forecasts generally included the proviso that a depreciation would or could occur, and they were accompanied by alternative scenarios involving such outcomes. As we have stated before, the Bank hoped the króna would remain strong until the economy had cooled off a bit, siphoning off some of the inflationary pressure generated by a drop in the exchange rate. So the depreciation as such did not take the Bank by surprise, but no one could have foreseen exactly when it would happen.


Question: An economics professor at the University of Iceland said recently that it had been a mistake not to have begun strengthening the foreign reserves much sooner. He said it should have been done as early as 2000, when the banks’ turnover began to grow so rapidly. Do you agree that it is a mistake not to have begun much sooner to build up the foreign reserves?


Chairman of the Board of Governors: There’s a lot of Monday-morning quarterbacking going on just now. But if it is true that the scholars at the University of Iceland foresaw the crunch that took place in the foreign exchange market in July and August of 2007, then I think they should have spoken up. They could have saved the global markets vast amounts of money. So it’s a shame they didn’t enlighten us sooner. On the other hand, it is correct that, after the Bank abandoned the exchange rate target, a battle that had cost it a large sum in foreign currency, it went on to increase its foreign reserves at a measured pace, so that by various standards, the level of the Central Bank’s foreign exchange reserves had become quite high. Then, at a later stage, a separate decision was made to double the reserves, and no matter what is being said now, no one had a thing to say about that back then. I can’t remember a single person – professor or anyone else – expressing his approval at the time. But now the Monday-morning quarterbacks have shown up, and it’s good to have them. It would also be fun to hear meteorologists tell us all about the weather that should have been different three years ago.


Question: The banks have more or less stopped lending. Is there anything that can be done to get them going again?


Chairman of the Board of Governors: We will return to normalcy once the banks regain proper access to credit. Fortunately, we are seeing signs that the doubts about the Icelandic banking system, which were reflected in the CDS levels, seem to be subsiding. We were looking at spreads of between 800 and 1100 basis points, levels that at the time were clear indications that Icelandic banks wouldn’t have access to credit. Fortunately, this has changed dramatically in the recent term, especially in the past few weeks, and although terms are still not as favourable as we would like, they are beginning to resemble the levels seen elsewhere, and we hope Icelandic banks will soon have access to the markets again. Perhaps it will be a bit costly at first, but the trend is clearly moving in the right direction, where the banks should soon be able to fund themselves as they are accustomed to, and then banking services will get back to normal.


Question: As regards the foreign exchange market – and its requirements?


Chairman of the Board of Governors: The Minister of Finance has decided to increase authorisations for securities issuance. I think it’s 25 billion, but it will depend on the outcome of the auctions next week. In the first phase, on Tuesday, I think it’s 15 billion. The Central Bank has previously taken certain measures, as you know, concerning its certificates of deposit. Actually, there are also signs of growing investor demand, based on the current exchange rate and interest rate levels.


Question: Is the answer 15 billion or 25 billion?


Chairman of the Board of Governors: It’s 25 billion in two phases: 15 and then 10.


Question: 15 on Tuesday?


Chairman of the Board of Governors: Yes, I think that’s correct.


Question: When is the latter phase?


Chairman of the Board of Governors: In the next auction. I guess it will be fairly soon.


Ingimundur Fridriksson: I believe it will depend on the response to the coming auction.


Chairman of the Board of Governors: We expect a positive response.  This is Government paper that has been very much in demand and has been in short supply. This is what has been decided so far, and when further decisions are made, they will be announced in due course.


Ingimundur Fridriksson: This information is available on the stock exchange website as well.


Question: Is this a recent decision?


Chairman of the Board of Governors: I think the Minister of Finance signed the authorisations yesterday, so yes, it’s a relatively recent decision.


Question: Do you not foresee yet that the policy rate reduction can begin earlier than was forecast?


Chairman of the Board of Governors: We don’t foresee it happening in the immediate future, but on the other hand, we are assuming that – despite a spurt of short-term inflation, and we are expecting that inflation measurements will be unfavourable in the near term – we are assuming that the current policy rate will suffice to restrain the economy. But of course, there are various global pressures at the moment. We have seen oil prices rising to 135 dollars, for example, and some are forecasting that they will hit 200 dollars before the year is out. So there are a number of difficulties on the horizon. Market expectations suggest that the US Federal Reserve Bank’s downward cycle may be coming to an end because of mounting concerns about inflation. The same could be said of market expectations in Europe. Statistics from Germany give no indication that the European Central Bank will lower interest rates, and the same has been reported from the UK: that because of inflationary pressure, the Bank of England may be unlikely to continue lowering interest rates in the near future. There is still considerable global concern, which is perhaps reflected in the markets – for example, yesterday and the day before yesterday.


Question: Isn’t this inflation of a type that won’t respond to downward pressure on demand? Is this cost-generated inflation?


Chairman of the Board of Governors: In general, there are exogenous factors at work, but there are also various other elements that contribute to the fact that the central banks in the US, the UK, and Europe, for example, appear to have taken the tack I described. Actually, the Norwegian central bank has been raising its policy rate. We have a much higher policy rate than these banks do, of course – many times higher, in some instances – but we think we can see that, if nothing changes for the worse, we can depart from this path within the time frame we have previously suggested.


Question:  We have seen some activity in the bond market recently; does this tell us something about inflation expectations?


Arnór Sighvatsson: It’s difficult, perhaps, at this point in time, to read too much into the bond market about what inflation expectations are exactly. Various exogenous factors have been interfering, but of course we had some concerns because, as far as we can see, inflation expectations appear to have risen from where they were before, even in the long term. We reported on this in the last Monetary Bulletin. In essence, things have not changed greatly since then.


Question: In the April 10 issue of Monetary Bulletin, you projected that real estate values would fall by 30% in real terms. There was no particular rationale given for it. Do you stand by that forecast?


Chairman of the Board of Governors: Actually, I think it was well grounded, but I don’t think there’s any reason to depart from that forecast.