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English
translation of a speech by Birgir Ísleifur Gunnarsson, Chairman of the
board of Governors, Central Bank of Iceland, at a seminar, October 31,
2001, organised by the Iceland Trade Council, Euro Info office in
Iceland and the EU Commission on the theme: Does the Euro affect
Iceland'
Ladies
and Gentlemen:
The evolution of European integration during the
second half of the last century is remarkable in many ways. This process
began soon after the end of World War II and represented an effort to
forge stronger bonds between European nations and thereby, among other
things, reduce the likelihood of further conflict on the continent.
Although I shall not go into its history here, many notable milestones can
be cited along the course that has been taken. One of the most notable was
the formal establishment of the Economic and Monetary Union in the
beginning of 1999. Now the abolition of the individual member nations'
separate currencies is in sight. As of next year they will be replaced by
Euro notes and coin. Not only will prices of goods and services be
calculated and stated in a single currency in the twelve EMU countries,
but the same notes and coin will be used for business in them all. One
consequence of pricing in a single currency in all member countries will
be to facilitate buyers of goods and services greatly in making price
comparisons, and competition within the EU will certainly become more
active than it has been until now.
Economic and Monetary
Union
The EMU has a population of more than 300 million and
accounts for 16% of global GDP. By way of comparison, the USA has a
population of 280 million and accounts for 22% of global GDP. Exports of
goods and services are equivalent to 19% of EMU GDP, while the
corresponding figure for the USA is under 11%. Some 19% of total world
merchandise exports come from the EMU, and 15% from the USA.
Twelve
of the fifteen EU nations belong to the EMU. The UK, Denmark and Sweden
remain outside it, but their positions differ somewhat. Denmark and the UK
have stated reservations about membership, on which they have reached
agreement with other EU states. Sweden, on the other hand, has opted to
remain outside the EMU, although no special reservations have been agreed
upon for them. Denmark is involved in currency cooperation with the EMU,
one aspect of which is that the exchange rate of the Danish krone may not
deviate from the Euro by more than 2.25% from a defined central rate.
Denmark therefore enjoys limited monetary independence. This is reflected
in the fact that the Danish Central Bank invariably alters its interest
rates in the wake of announcements of changes in the European Central Bank
(ECB) policy rate. Sweden and the UK have opted for inflation targeting as
their monetary policy framework, which therefore does not have the
objective of keeping these countries' currencies stable against the
Euro.
European Central Bank
The Maastricht Treaty
stipulates monetary arrangements in the EMU. The EU countries created a
framework for the ECB's activities which was to some extent modelled on
the Central Bank of Germany but differed in many ways from the
arrangements in others. Various conditions were set which EU members had
to fulfil in order to be granted EMU membership. On the one hand these
related to major components of economic developments, such as inflation,
fiscal deficit, government debt and interest rates. On the other hand they
addressed the framework that the Maastricht Treaty lays down for monetary
policy implementation in the EMU.
This policy was consistent with
growing support for the view that it was natural to set a simple target
for central banks - i.e. promoting price stability - and to increase their
independence from the political leadership in pursuing their main
objectives, and to strengthen their financial independence. Another
emphasis was that, at the same time as the central banks' independence was
strengthened, stricter demands would need to be made of them regarding
transparency in their activities and actions, and regarding accountability
towards the government and general public.
All this was reflected
in the Maastricht Treaty. The European Central Bank, which formally began
operation in the middle of 1998, enjoys extensive independence and is
subject to requirements for transparency and accountability. Even though
Sweden is not yet a member of the EMU, it amended legislation on its own
Central Bank which now largely fulfils the Maastricht terms. The Bank of
England's legislation does not entirely fulfil the terms of the treaty,
but it was granted greatly increased independence a few years ago. Denmark
has still not amended its central bank legislation, although this will
need to be done in the event of Denmark joining the EMU, not least to give
legal sanction to its independence.
Price stability is the main
objective
The Maastricht Treaty set a single objective for the
European Central Bank, namely ensuring price stability. Price stability
was not defined in the treaty, however; this was done by the ECB itself,
which specified it as an annual rise of under 2% in the Harmonised
Consumer Price Index. A separate treaty on stability and economic growth
stipulates that EMU members should aim for long-term fiscal balance or a
surplus, and a public sector deficit of less than 3% of GDP.
The
decisive viewpoints behind the formulation of the European monetary
framework were also dominant in many other parts of the world. Examples
are industrialised nations such as Australia and New Zealand, while
numerous others, such as the transformation economies of Eastern Europe
and newly industrialised countries in Latin America and Asia amended their
legislation to reflect the main principles of simple target-setting,
independence and transparency.
Even though Iceland was not a party
to European monetary cooperation and there was no outlook for a change in
this situation for the foreseeable future, the Central Bank of Iceland
felt that it ought to monitor developments as closely as possible. The
forerunner of the ECB, the European Monetary Institute, was founded in the
beginning of 1994 and the Central Bank of Iceland soon established formal
relations with it. This continued after the ECB began operation. Central
Bank experts have also had ready access to ECB experts on various issues
concerning the formulation and, not least, the implementation of monetary
policy. One fruit of the Central Bank's work in this area was a
comprehensive report published in mid-1997 on the Economic and Monetary
Union.
The Central Bank of Iceland changed its monetary
instruments
In March 1998 the Central Bank of Iceland made an
extensive reform of its monetary instruments. The guiding principle was to
bring these instruments into line with those already decided for the ECB,
even though it had not yet become functional. Consequently, since this
time the Central Bank of Iceland has employed working procedures which in
principle are analogous to those used by the ECB. The main difference is
in the repurchase agreement auction format. Hitherto, the Central Bank of
Iceland has auctioned unlimited amounts at a fixed rate of interest.
Initially the ECB decided both the interest rate and total amount of its
repo auctions at any time. The result was that the ECB only accepted a
fraction of the bids made for its repos. This arrangement was abandoned
and more recently the ECB has invited bids for a specific amount, but not
at any predetermined rate of interest. Amounts are decided on the basis of
the ECB's assessment of the credit institutions' liquidity requirement and
the money market interest rates which it aims to achieve. One reason for
the ECB's choice of this format is that the various EMU central banks
operated different arrangements for liquidity facilities before the ECB
was established, and different viewpoints needed to be reconciled.
Regarding other aspects of central bank activities and their
effect in Iceland, it should perhaps first be pointed out that the Central
Bank of Iceland began increasing the transparency of its activities and
actions long ago. Among other things, this is reflected in the Bank's
efforts to explain more clearly its policy and assessment of the economic
and monetary situation and outlook. One step in this direction was taken
towards the end of 1999 with a thorough review of the Bank's publishing
activities. It ceased publication of Monthly Statistics, which had
appeared since 1974, and launched the quarterly Monetary Bulletin
which provides a much better forum than earlier publications for
presenting in-depth explanations of the Bank's assessment of the economic
and monetary situation and outlook, its measures in domestic markets and
its policies. Furthermore, the new bulletin created an opportunity to
present other material which directly or indirectly concerns the Bank's
policy. It was also decided that the bank's quarterly inflation forecast
would be published in Monetary Bulletin. Thus Monetary
Bulletin can be described as the main platform today for the Central
Bank's accountability towards the Government and general public.
New Central Bank Act
The most important milestone in
the changes affecting the Central Bank, however, was reached this year
with new legislation passed by parliament. A committee appointed by the
Prime Minister at the end of last year submitted its proposals for a draft
Central Bank Act in March. The bill was presented to parliament in the
beginning of April and such a broad consensus was reached that it was
passed with the unanimous votes of all 56 members of parliament who
attended the final vote. The new Central Bank Act is closely modelled on
the legislative framework that had been created for central banks in other
countries in recent years, including the EMU. A simple target was set for
the Central Bank of Iceland, i.e. to promote price stability, it was
granted full independence to use its instruments, its financial
independence was ensured and legal requirements were made for transparency
and accountability, along with other points. I think it is fair to say
that the new Central Bank Act generated interest internationally, not
least for the speed at which the legal review was made and the broad
consensus achieved on the reforms.
The Central Bank Act authorises
the declaration of a numerical target for inflation, subject to the Prime
Minister's approval. This provision incorporates into law the policy
introduced on March 27 this year when the monetary framework was changed
and the flexible fixed exchange rate was replaced with an inflation target
and floating exchange rate. Despite very detailed discussion of the
framework changes and the fundamental principles of the new policy, the
Bank has often noticed widespread misunderstandings. I shall therefore
outline the broad principles of monetary policy.
Inflation is a
monetary phenomenon
The Central Bank was assigned a specific
inflation target in the joint declaration which it issued, with the
Government, on March 27. This stipulated that the Bank should aim for a
rate of inflation as close as possible to 2½%. Tolerance limits were also
set, 1½% higher than the inflation target and 1½% lower. The inflation
target was defined as the twelve-month rise in the CPI. If inflation
exceeded the tolerance limits, the Bank would be obliged to bring it back
within them as quickly as possible. At the same time the Bank would be
obliged to submit a report to the Government, which would be made public,
stating the reason for the deviation, its planned response and the length
of time that it expected to take to bring inflation back within target.
When the target was set, inflation was running relatively high in Iceland.
Bearing that in mind, the upper tolerance limit was set for 6% this year,
4½% in 2002 and then 4% from the year 2003 onwards.
Upheavals in
the foreign exchange market in the spring and a sharp depreciation of the
króna caused a substantial rise in inflation, which exceeded the upper
tolerance limit in June. The Central Bank submitted a detailed report to
the Government on June 20. Other aspects of the joint declaration included
a provision that, notwithstanding the abolition of the exchange rate
target band, the Central Bank would intervene in the interbank market in
foreign exchange by buying and selling currency if it deemed this
necessary in order to contribute towards attaining the inflation target,
or if it viewed exchange rate swings as a threat to financial stability.
At the same time, the Central Bank undertook to produce a quarterly
inflation forecast projecting two years into the future.
It should
be remembered that one of the main reasons for the simplification of
central bank targets in recent years, and for assigning them the main
objective of price stability, is that inflation is primarily a monetary
phenomenon and the long-term impact of monetary policy is above all on
prices. Its impact on economic growth and employment is therefore
generally only temporary. Since central banks broadly speaking have only
one instrument, i.e. interest rates, and can therefore only achieve a
single long-term macroeconomic goal, it is natural to set price stability
as the ultimate monetary goal. This is not to say that price stability is
a more important goal than, say, full employment, but simply that monetary
policy instruments are inherently better suited to impacting prices. It is
pointless to set objectives for monetary policy which it cannot achieve.
Through price stability, a forward-orientated monetary policy can
contribute towards creating a stable economic environment on which the
long-term growth potential of the economy is based.
From the above
it is clear that the Central Bank's main task is to achieve the inflation
target, and this is what it aims to do. There have been vocal calls
recently for the Central Bank to ease its monetary stance in order to
soften or even prevent a looming economic contraction. The growth outlook
has an impact on the output gap, i.e. the deviation in demand from a level
which is consistent with balanced supply and demand for domestic goods and
factors of production. The output gap is subsequently one of the factors
that play a key role in the inflation cycle. All things being equal, the
growth outlook thus exerts an influence on monetary policy, namely the
worse the outlook, the lower the interest rate, and the contrary. For as
long as inflation remains at its present high level, however, it is
unavoidable to allow the output gap to shrink sufficiently and the Central
Bank cannot apply its instruments at this stage to prevent that happening.
High interest rates are counter-inflationary
The
Central Bank has held the view that, until clear signs emerge that its
August inflation forecast will hold good, it is still not safe to lower
interest rates. Impulsive action could entail a risk that inflation will
magnify even further, with very dire consequences for households,
businesses and economic growth conditions. Claims have also been heard
that Iceland's high interest rates are inflationary rather than
counter-inflationary. The Central Bank does not agree with this view,
which cannot be supported with economic theories, studies or research. On
the contrary, there is every indication that interest rates have a similar
effect in Iceland to that elsewhere. The Icelandic economy was showing
signs of strong overheating which apparently peaked last year. It is
beyond doubt that the tight monetary stance made a major contribution
towards cooling the economy. And such a winding down was necessary, too,
since great macroeconomic imbalances had emerged, reflected most clearly
in an unacceptable current account deficit and inflationary pressures. It
is therefore inevitable that the output gap will narrow in order to bring
down inflation, and that national income will drop even further in order
to achieve a significant reduction in the current account deficit, which
is far beyond a sustainable long-term level.
High interest rates
can be painful, not least for the households and businesses that have been
imprudent in their consumption and investments recently and have relied
too heavily on the facilities of credit institutions. It is out of the
question for the Central Bank to base its interest rate policy on the
actions of the least prudent members of the community. This can only be
based on provisions made in laws and the joint declaration by the
Government and the Central Bank this March, i.e. to promote price
stability. This is the guiding aim of central bank activities in
industrial countries around the world, because it creates a climate for
economic growth and greater well-being for citizens. In a world of free
capital movements and greatly enhanced access to credit compared with
earlier times, businesses and households, and credit institutions too,
must find their bearings for themselves.
Understandably, many
people complain about high interest rates, but the lively debates in
recent weeks have often revealed excessive faith in the effect that an
interest rate cut would have on economic developments. A slowdown in
economic activity is not solely caused by interest rates. Other factors
that deserve to be mentioned are the contractionary impact of fishing
quota cuts, the downturn in the IT sector which is closely linked to
global trends, and fluctuations in power-intensive development projects
which are unaffected by domestic interest rates. Cutting interest rates
now would have a limited immediate effect on the supply side of the
economy, while high interest rates act with full force on the demand side
where they serve to reduce inflation and domestic demand, which will
contribute to improved macroeconomic balance and low inflation.
Iceland's currency options
I have outlined various
aspects of the Central Bank's monetary policy. As I mentioned, Iceland has
not taken part in European currency cooperation. Various currency
framework options that Iceland ought to consider are often named in public
discussions. A detailed account of most of them was given in the Central
Bank's 1997 report on the EMU. It is frequently said that Iceland ought to
adopt the Euro as its currency, either unilaterally or through associate
membership of the EMU. I strongly warn against simplifying the options
available to us in this respect. Even if associate membership were being
offered, which does not seem likely, it seems fair to assume that any
country which was interested in it would need to fulfil the Maastricht
Treaty requirements for EMU membership. These include a rate of inflation
no higher than 1½% above that in the three EU countries where it is
lowest, a one-year record of average nominal interest rates on long-term
bonds no more than 2% higher than in the three EU countries where
inflation is lowest, and membership of the ERM for at least two years
without devaluing the currency and without exceeding the deviation band.
Iceland will obviously not be fulfilling these conditions in the immediate
future. Some form of EMU membership in the future would therefore not
release Iceland from the obligation to bring inflation down to a similar
level to that among its trading partner countries. It may be added that
even if Iceland fulfilled all these conditions, it is extremely unlikely
that it would be able to negotiate, in the foreseeable future, associate
membership of the EMU or some kind of other bilateral currency cooperation
with it. All the signs point in the opposite direction, whatever the
phrasing of individual articles in the Treaty of Rome and Maastricht
Treaty might suggest. Furthermore, it should be pointed out that twelve
Eastern European countries are waiting to be admitted to the European
Union and, later, the EMU. The ECB and Community leadership have firmly
underlined that these nations should fulfil all the conditions for
participation in EMU. Thus the EU is highly unlikely to agree to set any
precedent which these nations could take advantage of as a short-cut into
the EMU.
Iceland has chosen to remain outside the EU and has not
declared an interest in membership. If Iceland were to show an interest in
adopting the Euro as its currency, the most obvious course would be to
join the EU with all the advantages and obligations that this entails,
including membership of the EMU. Such a decision, however, depends on more
factors than just the national currency, and this process would take a
good many years. Of course, this is a highly political question and
therefore outside the scope of this address. We need to continue to find
our bearings in the global community as a nation with its own currency,
which in an environment of free capital movements calls for very
disciplined economic policy implementation.
Ladies and
Gentlemen:
Representatives of all EU countries were involved in
formulating and developing the Economic and Monetary Union. They created a
monetary framework within the EMU which they regarded as serving the
Community's citizens best. Although Iceland stands outside the EMU, we
have incorporated into our monetary policy implementation much of what the
EU countries agreed that best served their interests. I am convinced that
we will benefit from this.
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