2011•2 2011•2 Contents 3 Statement of the Monetary Policy Committee 5 Economic and monetary developments and prospects Weaker outlook and greater uncertainty Boxes: Housing bubbles 23 Survey of large corporations' investment 29 Exchange rate pass-through 46 Appendix 1: Baseline macroeconomic and inflation forecast 2011/2 49 51 Monetary policy and instruments 55 Economic and monetary chronicle 69 Tables and charts 79 Boxes and appendices The objective of the Central Bank of Iceland’s monetary policy is to contrib- ute to general economic well-being in Iceland. The Central Bank does so by promoting price stability, which is its main objective. In the joint declaration made by the Government of Iceland and Central Bank of Iceland on 27 March 2001, this is defined as aiming at an average rate of inflation, meas- ured as the 12-month increase in the CPI, of as close to 2½% as possible. Professional analysis and transparency are prerequisites for credible mon- etary policy. In publishing Monetary Bulletin four times a year, the Central Bank aims to fulfil these principles. Monetary Bulletin includes a detailed analysis of economic developments and prospects, on which the Monetary Policy Committee's interest rate de- cisions are based. It also represents a vehicle for the Bank’s accountability towards Government authorities and the public. The framework of monetary policy and its implementation and instruments are described in the chapter entitled "Monetary policy and instruments", on pp. 51-53 of this edition of Monetary Bulletin. Published by: The Central Bank of Iceland, Kalkofnsvegur 1, 150 Reykjavík, Iceland Tel: (+354) 569 9600, fax: (+354) 569 9605 E-mail: [email protected] Website: www.sedlabanki.is Editorial Board and staff: Thórarinn G. Pétursson, chairman Sturla Pálsson Tómas Örn Kristinsson Tryggvi Pálsson Rannveig Sigurdardóttir Gudjón Emilsson Vol. 13 no. 2 20 April 2011 Printing: Ísafoldarprentsmiðja Monetary Bulletin is also published on the Central Bank of Iceland website. ISSN 1607-6680 Material may be reproduced from Monetary Bulletin, but an acknowledgement of source is kindly requested. Icelandic letters: ð/Ð (pronounced like th in English this) þ/Þ (pronounced like th in English think) In Monetary Bulletin, ð is transliterated as d and þ as th in personal names, for consistency with international references, but otherwise the Icelandic letters are retained. Symbols: * Preliminary or estimated data. 0 Less than half of the unit used. - Nil. ... Not available. Not applicable. Statement of the Monetary Policy Committee 20 April 2011 The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank’s interest rates unchanged. The deposit rate (current account rate) will remain 3.25%, the maximum bid rate for 28-day certificates of deposit (CDs) 4.0%, the seven-day collat- eralised lending rate 4.25%, and the overnight lending rate 5.25%. The current interest rate decision is influenced by opposing fac- tors. On the one hand, the inflation outlook has deteriorated, at least in the near term, inflation expectations have drifted upwards, and real Central Bank rates have fallen significantly. Moreover, risks to the ex- change rate outlook have increased in the aftermath of the Icesave referendum. On the other hand, the outlook for growth and employ- ment has deteriorated according to the Central Bank’s baseline fore- cast, published today in the Monetary Bulletin, with additional risk to growth stemming from the result of the referendum. In spite of weaker activity, inflation expectations have risen re- cently and the medium-term inflation outlook has deteriorated. Head- line inflation has increased for two consecutive months, to 2.3% in March. It is forecast to peak at just above 3% later this year and remain elevated until early next year. Higher inflation than previously forecast primarily reflects a weaker króna and the recent rise in commodity and oil prices. To the extent that these price increases are temporary, they are unlikely to have a lasting effect on longer-term inflation expecta- tions and wage- and price-setting. Assuming a stable króna and given the spare capacity in the economy, inflation is forecast to fall back to target in the latter half of 2012. However, draft wage agreements im- ply pay increases that may prove larger over the medium term than is consistent with the inflation target. The planned capital account liberalisation has limited short-term implications for the monetary policy stance because the first steps of the two-phase strategy should be broadly neutral in terms of their impact on the foreign exchange reserves. The result of the Icesave referendum on 9 April has tilted risks to the exchange rate to the downside, as it may affect the sovereign credit rating and hence the terms at which Iceland can borrow in for- eign capital markets. This may limit the MPC’s room for manoeuvre over the medium term. It may also affect the pace of capital account liberalisation. However, this is mitigated by the likelihood that the pro- gramme with the IMF will be unaffected. The direction of future policy moves remains uncertain. The MPC stands ready to adjust the monetary stance as required to achieve its interim objective of exchange rate stability and ensure that inflation is close to target over the medium term. 4 MONETARY BULLETIN 2011•2 Economic and monetary developments and prospects1 Weaker outlook and greater uncertainty Although the Central Bank’s real interest rate has continued to fall, the financial conditions of households and businesses remain difficult. It is now estimated that the economic contraction in 2010 was deeper than accord- ing to the Bank’s February forecast. Domestic demand was broadly in line with the forecast, however, and the difference is largely because domestic demand was directed more towards imports than had been assumed. Stronger import growth is also the main reason the GDP growth outlook for 2011 is poorer than in February. The prospects for GDP growth in 2012 and 2013 have also deteriorated. Current data suggest that the recovery in activity began in mid-2010, yet the recovery is weak. Considerable spare capacity remains in the economy and appears likely to continue over the forecast horizon. The poorer growth outlook has implications for the labour market outlook as well, and unemployment is now expected to subside more slowly than previously forecast. In spite of weaker activity, long-term inflation expectations have risen slightly in the recent term and the inflation outlook has worsened. Inflation is now projected to peak at just over 3% later in 2011, due pri- 5 marily to steep rises in commodity and oil prices. The króna is also expected to be weaker during the forecast horizon, and pay rises are expected to be larger and more front-loaded than the Bank previously assumed. 2011•2 BULLETIN MONETARY Nonetheless, when the impact of these transitory factors dissipates, the slack in the economy is expected to ensure that inflation subsides to target again in the latter half of 2012. The outlook is quite uncertain, however, and uncertainty has increased significantly due to the outcome of the Icesave referendum. Even though some indicators give cause for greater optimism, the downside risks to the outlook are considered to be greater than the upside risks. I Economic outlook and main uncertainties Central Bank rates lower than at last Monetary Bulletin publication The Central Bank’s Monetary Policy Committee decided to lower the Bank’s interest rates by 0.25 in early February, when the last Monetary Chart I-1 Central Bank of Iceland interest rates Bulletin was published, but then kept rates unchanged in March. As and short-term market interest rates this Monetary Bulletin went to press, the current account rate was Daily data 1 January 2010 - 15 April 2011 3.25%, the maximum rate on 28-day CDs 4.0%, the collateralised % lending rate 4.25%, and the overnight lending rate 5.25%. 12 Given the ample liquidity in the financial system, the Bank’s 10 effective interest rate can be considered to lie near the average of its 8 deposit rates – currently about 3.6% – and to have recently moved 6 closer to the CD rate and the centre of the interest rate corridor. This 4 can be seen, for example, in the fact that short-term interbank rates 2 have been closer to the centre of the corridor in 2011 than they were 0 2010 2011 in 2010. Overnight market rates have averaged just under 4% since the rate cut in early February. Collateral loan rate Overnight CBI rates Maximum rate on 28-day CDs Real short-term interest rate has fallen, but financial conditions CBI current account rates remain difficult for households and firms Overnight interbank rates Concurrent with the reduction in Central Bank rates and rising infla- Source: Central Bank of Iceland. tion expectations, the Bank’s real rate has fallen markedly and is currently below 1% averaging over different measures, which is a significant decline since the publication of Monetary Bulletin in early February. This reduction in the Bank’s real interest rate helps support recovery. 1. The analysis presented in this Monetary Bulletin is based on data available in mid-April. ECONOMIC AND MONETARY DEVELOPMENTS AND PROSPECTS This substantial easing of monetary policy has only partially been passed through to households and businesses, as their financial condi- Chart I-2 tions remain difficult. These problems in monetary policy transmission The ISK exchange rate against the euro - comparison with MB 2011/1 reflect, among other things, uncertainty about the financial strength of financial institutions and the quality of their assets, and higher lev- ISK/EUR 200 ies on banking operations. As a result, access to credit remains tight, 180 and lending rates are somewhat high.