The Central Bank Monetary Policy Committee’s (MPC) interest rate decisions affect other financial variables in Iceland, including other short- and long-term interest rates, financial system liquidity, money holdings, lending, currency exchange rates, other financial asset prices, and – last but not least – expectations concerning how all of these variables will develop in the future. All of this then affects households’ and businesses’ consumption and investment decisions. The Central Bank’s interest rates therefore affect aggregate demand in the economy, pressure to change prices, and ultimately, inflation.

The Central Bank’s interest rates in its transactions with financial institutions affect other short-term money market rates first, as the money market is where transactions with short-term securities take place. Through price formation in the financial market, the effects are transmitted across the yield curve. The Bank’s key interest rate (policy rate) is the rate on transactions with credit institutions that is the primary determinant of short-term market rates and therefore of the monetary stance. The interest rate that has the strongest effect on short-term market rates and is therefore considered the Central Bank’s key rate may change from time to time.

Changes in Central Bank interest rates have a broad impact on the domestic economy. For instance, Central Bank rate increases usually cause interest rates on savings, outstanding short-term debt, and long-term variable-rate debt to rise as well. This reduces the income that households and businesses with outstanding net liabilities have at their disposal after making interest payments. Households’ and businesses’ capacity to maintain an unchanged level of consumption and investment spending is then reduced unless they take on additional debt or tap their savings, both of which are more expensive when interest rates are higher. In the same manner, monetary policy affects households’ and businesses’ cost of financing new activities. All else being equal, higher interest rates therefore reduce households’ and businesses’ consumption and investment spending.

When interest rates are lowered, the same forces are at work, but in the opposite direction.

 Another channel for monetary policy transmission is through the exchange rate of the króna. If interest rates on domestic securities are higher than rates on comparable foreign securities, it will be more beneficial to own domestic securities, provided that the exchange rate of the króna remains stable. By widening the spread between domestic and foreign interest rates, the Central Bank can stimulate capital inflows or curb outflows; i.e., it can stimulate demand for krónur. Under normal circumstances, then, interest rate hikes contribute to a higher exchange rate than would otherwise occur, which in turn tends to lower import prices and inflation, all else being equal. Because movements in the exchange rate of the króna change relative prices of domestic versus foreign goods and services, thereby affecting the competitive position of domestic firms vis-à-vis foreign competitors, they also affect external trade and domestic demand. When the króna appreciates, foreign goods become relatively less expensive than before, which directs demand outside the domestic economy – again, all else being equal. Demand for domestic production therefore contracts, which should also lead to lower inflation.

Central Bank interest rates can also affect the price of assets – equity securities and real estate – thereby affecting households’ and firms’ net wealth. Absent other changes, higher interest rates should lead to lower equity securities prices. There are three reasons for this: first, the present value of expected payment flows in connection with the securities will decline; second, when interest rates rise, demand for bonds increases at the expense of demand for shares, and reduced demand for shares can cause their prices to fall; and third, higher interest rates could increase firms’ financing costs and cut into their profits, which are the premise for payment of dividends to shareholders. By the same token, mortgage interest expense rises, dampening demand for housing and easing upward price pressures in the housing market. Declining share and house prices reduce individuals’ wealth, thereby reducing their proclivity and capacity to spend. Lower share prices also reduce firms’ market value, which makes it relatively less favourable to issue new share capital to finance new development.

Finally, monetary policy affects general expectations of future developments in factors such as GDP growth and inflation, and the uncertainty attached to such expectations. Changes in expectations affect the behaviour of financial market agents and others, including individuals’ expectations about the employment outlook and businesses’ expectations about future sales and profits. An increase in Central Bank interest rates can be interpreted to mean that the Bank considers it necessary to slow down economic activity so as to bring inflation to target. In such cases, the GDP growth outlook will have deteriorated in the wake of the interest rate hike, but the likelihood of price stability will have been enhanced. If the monetary policy measure is credible, it should lower inflation expectations and support the actions taken by the Bank to keep prices stable.

International research suggests that in general, the impact of monetary policy measures begins to show approximately six months later, and that the bulk of the impact will be discernible one year later. The first effects on domestic inflation generally appear after about a year, and the bulk of them come to the fore by about 1½-2 years after the rate increase. The transmission mechanism in Iceland is broadly as is described in the handbook for the Bank’s quarterly macroeconomic model (QMM)

It is worth emphasising that the monetary policy transmission mechanism is subject to change and is highly uncertain as regards, for instance, the strength of the ultimate impact and the time lag between changes in central bank interest rates and the effects of those changes on the domestic economy. It is likely that the effectiveness of monetary policy is determined to a large degree by the effect it has on the general public’s expectations and the level of confidence it enjoys. It is therefore vital to bolster such confidence by conducting monetary policy in a transparent and credible way.