Download Olafsson`s presentation, May 16, 2008 (PP-file)

Seðlabanki Íslands
The Icelandic Saga
Conducting monetary policy with the smallest freely floating
currency in the world through periods of ample global
liquidity and credit crisis
T. Tjörvi Olafsson
Economist, Central Bank of Iceland Economics Department
[email protected]
Presentation at the Federal Reserve Bank of New York
May 16, 2008
The opinions expressed in this presentation are those of the author and do not necessarily represent the views
of the Central Bank of Iceland.
Exchange rate performance against the euro
since 1 August 2007
CZK
CHF
HUF
BRL
JPY
AUD
TRY
USD
NZD
ZAR
KRW
-45
-35
-25
-15
-5
5
15
13
12
11
10
9
8
7
6
5
4
3
2
1
0
Japan
Canada
Switzerland
United
Norway
Euro area
Sweden
New Zealand
Slovakiet
South-Korea
Ísrael
USA
Poland
Australia
Mexico
Brazil
Tailand
Peru
Rumenia
Columbia
Phillipiens
Hungary
Czech republic
Indonesia
Chile
Turkey
Ghana
South-Africa
Iceland
Damaging effects of the crisis …
Chart
CPI inflation
PLN
%
ISK
Sources: Central Bank websites
… due to lack of confidence …
CDSs of Icelandic banks and Itraxx Financial
Index
Daily data May 23, 2006 - May 13, 2008
Points
1100
1000
900
800
700
600
500
400
300
200
100
0
maí.06
okt.06
feb.07
júl.07
des.07
maí.08
Expectations of twelve-month inflation
according to the difference between forward
nominal and indexed interest rates
12%
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
1
2
3
4
5
6
7
Kaupthing
9
Years
Itraxx Financial Europe
8.11.2007
13.5.2008
Glitnir
Landsbanki
Inflation target
14.4.2008
Sources: Bloomberg, Reuters.
Heimildir: Bloomberg, Reuters.
8
Source: Central Bank of Iceland
... reflecting domestic vulnerabilities
Sharp turnaround underway
Overview
• Rapid expansion in times of ample global liquidity,
large demand shocks and the build-up of large
macroeconomic imbalances
• Challenges of independent monetary policy in very
small open economies unwinding these
imbalances
• Out-of-sync with the global monetary cycle
• Importance of credibility and transparency
• Financial accelerator/decelerator mechanisms,
carry trade and sudden-stops
• Main task of monetary policy: Restore confidence
• Anchor inflation expectations and stop the rapid
depreciation of the Icelandic currency
• Liquidity provision in foreign currency
Basic information on Iceland
• Very small open economy: 300,000 inhabitants
• From poverty to riches in the 20th century through utilisation
of its abundant natural resources
• Historically a volatile economy due to resource-based
exports and external supply shocks
• Controlled economy for a longer period than most other
developed countries
• History of high and volatile inflation
• Significant structural reforms over the past two decades
• Market liberalisation, privatisation, fiscal consolidation
• Disinflation in 1990s but unsustainable fixed exchange rate regime
• Inflation targeting since 2001
• Diversification of the economy and embracement of
globalisation
• Still high exchange rate pass-through
Inflation targeting adopted in 2001
• New Central Bank Act in May 2001 and a
joint declaration of the government and the
bank
• Significant departure from previous regimes
of different types of currency pegs
• Long history of using the exchange rate as a
monetary anchor with a varying degree of
commitment resulting in high inflation
Price stability main objective …
• Price stability defined as the Bank’s single
main objective
• Inflation target specified as inflation of 2½%,
measured in terms of twelve-month rate of
change in headline CPI (house prices
included)
• The Central Bank granted full independence
to attain its objective
• Transparency and accountability
strengthened
• In line with best practice around the world
... but expectations remain unanchored
Disappointing results
• Inflation has on
average been 4.9%
since inflation targeting
was adopted in 2001
• Inflation has been
volatile, it reached a
low of 1.6% and is
currently at a high of
11.8%
CPI inflation with and without housing
%
12
10
8
6
4
2
0
-2
2001
2002
2003
2004
2005
2006
CPI inflation
Inflation target
CPI inflation without housing
Source: Statistics Iceland
2007
2008
Booming economy
• Credit boom:
– Privatisation of the banks completed in 2003
– Historically low global interest rates and easy access to
cheap foreign-currency borrowing
• Investment boom:
– Aluminium smelters and power stations
– 30% of GDP in 2003 spread over three years
• Asset price boom:
– Real house prices up by 128% from 1997
– Equity prices up by 550% from Jan. 2003 to July 2007
• Consumption boom:
– Real disposable income rose rapidly
– Lowering of taxes and explicit promises
– Wealth effects and easier access to credit
Expansion abroad …
Total assets of the largest commercial
banking groups as % of GDP
% of GDP
900
800
700
600
500
400
300
200
100
0
1996
1998
2000
2002
2004
2006
Total assets of the largest commercial banking
groups as % of GDP
Source: Central Bank of Iceland
… fuelled by ample global liquidity
Global liquidity index and equity price
index in Iceland
Global liquidity index and total assets and
liabilities
% of GDP
700
1.0
0.8
600
0.6
500
0.4
0.2
400
0.0
300
-0.2
-0.4
200
-0.6
100
-0.8
-1.0
1999
1.0
9,000
0.8
8,000
0.6
7,000
0.4
0.2
6,000
0.0
5,000
-0.2
4,000
-0.4
3,000
-0.6
2,000
-0.8
0
2001
2003
2005
2007
Bank of England financial market liquidity index (left)
Total liabilities as % of GDP (right)
-1.0
2002
1,000
2003
2004
2005
2006
2008
Bank of England financial market liquidity index
(left)
OMXI15 equity price index (right)
Total assets as % of GDP (right)
Sources: Bank of England, Statistics Iceland, Central Bank of Iceland
2007
Sources: Bank of England, OMX Stock Exchange
Large capital inflows, now a sudden stop
Global liquidity index and the financing of
Iceland's current account deficit
b.kr.
-1.0
20
-0.8
0
-0.6
-0.4
-20
-0.2
0.0
-40
0.2
-60
0.4
0.6
-80
0.8
1.0
1999
-100
2001
2003
2005
2007
Current account in b.kr.(right)
Bank of England financial market liquidity index
(left, reverse scale)
Sources: Bank of England, Statistics Iceland, Central Bank of Iceland
Challenges to monetary policy
•
•
Large demand shocks, some anticipated
Should be business as usual for monetary
policy making - why such disappointing
results?
–
–
–
–
–
–
Too reluctant to raise rates?
Credibility issues?
Faulty analysis and data?
Institutional framework hindering an effective
transmission of monetary policy?
Insufficient support from the fiscal authorities?
Special problems in conducting monetary
policy in very small open economies?
Challenges to monetary policy (cont.)
• Financial accelerator effects:
– Household, corporate and bank balance sheets
have multiplied in size as the commercial banks
and firms have expanded abroad and equity
and house prices have risen briskly
– Icelanders took advantage of easy access to
foreign credit, leverage increased rapidly and
macroeconomic imbalances built up
– The Icelandic economy was therefore
vulnerable when the credit crisis emerged and
financial decelerator effects are gaining
momentum
Households
Private sector credit
Communication problem ...
•
•
•
•
Limited credibility
Illiquid markets
Unpredictable
monetary policy
Large imbalances
create large
uncertainties
regarding prospects
Publication of own policy rate path …
... has had some positive effects …
... but challenges remain
Swap agreements with Nordic banks
• Lack of access to
foreign currency
liquidity facilities
• Swap market failure
• Depreciation of the
króna
• Swap agreements with
three other Nordic
central banks
announced today
– Precautionary measure
– 500 million EUR each
• Strengthening króna
Mynd 4
Chart 1
FX swap-implied ISK rates minus EUR Libor
and the Icelandic króna
Daily data, August 2007 - May 2008
%
EURISK
12
82
10
90
8
98
6
106
4
114
2
0
122
-2
130
ágú.07 sep.07 okt.07 nóv.07 jan.08 feb.08 mar.08 maí.08
1-month interest rate diffential (left)
3-month interest rate diffential (left)
EURISK, reversed (right)
Sources: Bloomberg, Central Bank of Iceland.
Final remarks
• Smallest country in the world with a fully
freely floating currency
• Efficiency costs associated with such a
small currency area vs. the benefits of
macroeconomic stabilisation due to a shock
absorbing role of the exchange rate and
independent monetary policy
• Widely discussed in Iceland at the moment
Final remarks (cont.)
• Icelandic economy more volatile than most other
small open economies and hence attaining an
inflation target is more difficult
– Role of the exchange rate
• Specially challenging circumstances in the last few
years domestically and globally – how
representative of the years to come?
• Lack of credibility of monetary policy make Iceland
more vulnerable than e.g. New Zealand
• Lack of lender of last resort in foreign currency
make the commercial banks more vulnerable
• Monetary policy’s main aim is to restore credibility
as soon as possible, today’s measure is a step in
that direction