Inflation Targeting: The Icelandic Experience

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Inflation Targeting The Icelandic Experience

• Friðrik Már Baldursson
• Reykjavik University

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Inflation targeting in Iceland

• Began in March 2001 after pegged exchange rate
  regime came under intense pressure
• Followed in footsteps of many other countries
• New Zealand pioneer
• Norway, Sweden, Switzerland
• Eurozone, UK, Canada
• Krona was floated (and fell immediately) and CBI
  given the mandate of keeping inflation close to
  2.5 tolerance limits /- 1.5 (comparatively
  high target wide limits)
• Increasing transparency in accordance with the
  established code of conduct for inflation
  targeters
• Since 2006 unconditional inflation forecasts
  fan charts for policy rate
• Since April 2008 policy rate forecasts in numbers

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Exchange rate
IT regime begins March 27 2001 with floating of
krona and lowering of policy rate
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How are we doing?

• IT regime was initiated with floating the krona
  and a lowering of policy rate
• After a passthrough period of 1.5 years,
  inflation was brought down to target in November
  2002
• Began rising again in late 2004 and broke the 4
  barrier in beginning of 2005
• Since then inflation has never been near 2.5
• Over 4 in 35 out of 41 months since January 2005
• Now at 12
• Cannot be considered an acceptable performance
  seven years on
• Arnor Sighvatsson, Chief economist of CBI, June
  2 2008

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Inflation and policy rate
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CBI estimates of inflation expectations high and
volatile ...
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... in spite of comparatively restrictive
monetary policy
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Central bank policy rates
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The task is not easy ...

• Hunt (2008) estimates small macromodels of
  Iceland, New Zealand, Canada, UK and USA to
  derive efficient monetary policy frontiers
• ... Inflation stabilization is a considerably
  more daunting challenge in Iceland than in other
  industrial countries, even other very small
  industrial countries like New Zealand.
• Can expect inflation to be within 1-4 tolerance
  range 60 of the time or less
• Suggests that considerably wider tolerance limits
  are necessary to increase the probability that
  inflation will generally be within the limits

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Source Hunt (2006)
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... by any means

• Þórarinn Pétursson (2008) studies inflation
  volatility in a large sample of countries,
  including Iceland
• Finds that inflation volatility is influenced by
• Volatility of risk premium on currency
• Passthrough (higher in VSOEs, very high in
  Iceland)
• Transparency and credibility of monetary policy
  (as measured by shocks to forward-looking
  Taylor-rule)
• Based on these results Iceland will inevitably
  have high inflation volatility
• Credible and transparent monetary policy may help
• But it is unlikely that VSOEs and EMEs will be
  able to reduce inflation volatility to the level
  in the large and more developed countries
  (Pétursson, 2008)

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CBI policy appears to be predictable (Taylor rule)
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... but the numbers say otherwise
Source Pétursson (2008)
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The CBI ...

• ... has increased transparency and worked hard to
  establish credibility
• But this has proven to be difficult
• The bank has tried to bootstrap its level of
  credibility (Baldursson and Hall, 2008)
• Assuming more credibility, stability, and speed
  of convergence towards a low inflation
  equilibrium than appears to be the case in reality

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Time path of CBI inflation forecasts
Source Baldursson and Hall
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Inflation and inflation forecasts
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Why is the CBIs task difficult?
Source CBI
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(No Transcript)
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Volatility in GDP and exports
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Exchange rate volatility
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In general, financial globalisation appears to
have weakened interest rate channel of monetary
policy Long-term rates in IT countries change
with US rates ...
Source Mar Gudmundsson (2007)
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... while correlation of short and long domestic
rates appears weaker
Source Mar Gudmundsson (2007)
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Long rates in Iceland US 3-year correlations
between monthly changes(Apparently decline in NZ
AUS too )
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CBI estimates of inflation expectations
Source CBI
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Short vs. long rates in Iceland3 year moving
correlation between monthly changes
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Exchange rate channel remains

• But speculative capital flows can cause excessive
  fluctuations in exchange rate and other asset
  prices

Source CBI
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Carry trade glacier bonds
Source CBI
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Carry trade overall
Foreign currency forwards
Source CBI
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Households carry traded tooGrowth in banks
lending to households
Source CBI
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Exchange rate policy of CBI

• Bank does not have official policy on exchange
  rate
• But numerous statements from the Bank in recent
  years show that it was considered important that
  the krona would not fall
• Paths for exchange rate consistent with inflation
  forecast published in MB
• gt Semiofficial exchange rate target
• Implication weakened impact of monetary policy
• Encouraged carry trade
• Amplified asset market bubbles (stock market,
  housing)
• Strong exchange rate supports consumer confidence
  and consumption
• But CBI is in a Catch-22 situation due to fast
  passthrough
• 0.43 in 8 quarters, Petursson, 2008)

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Correlation of exchange rate and share
pricesFX-leveraged holdings and confidence
effect of exchange rate(?)
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Foreign currency forwards and options
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Exchange rate fell when banks CDS spread was
transmitted into swap rates
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Has monetary policy been too strict?

• Policy rate follows rule originally proposed by
  John Taylor (1993). Based on US data.
• From that perspective can hardly be too strict
  since the interest rate channel in Iceland may
  safely be assumed to be considerably weaker than
  in the US
• Are policy rules like that of Taylor appropriate
  for Iceland?
• Unlikely to be successful when effects of capital
  flows are taken into account, although rules on
  other economic policies might ameliorate problems
• However, policy rate bites with full force at
  present and is likely to have a strong impact, at
  long last

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Source CBI
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Should the inflation targeting regime be
abandoned as suggested by some?

• Performance can probably be improved
• Sighvatsson (2008)
• Better models, forecasts, national accounts
• Better communication and more developed financial
  markets
• Better government policies
• Increased power of CBI to regulate housing market
• Undoubtedly some of this would help. But due to
  fundamentals the task of sustaining inflation
  at stable low level is extremely difficult and is
  unlikely to succeed
• It would be unwise to abandon the inflation
  targeting principle
• Question is whether it would be wise to set more
  realistic targets
• Turkey did this a few days ago

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Iceland and Turkey exchange rates
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We must bring inflation down

• But only sustainable arrangement is to join EMU
• Can we do it? Need to satisfy Maastricht criteria
• Can we handle it? Some fundamentals need to
  change