Iceland Central Bank Statement

Author: | Published: 5 Sep 2017
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The Icelandic economy is currently booming after a few years of economic growth well in excess of longer-term potential. Fuelled by buoyant tourism, growth was particularly strong in 2016, at 7.2%. It is predicted to be in excess of 6% in 2017. The economy was probably already operating at full employment in 2015. In spite of this, recent growth has been associated with a relatively well-balanced economy, and the looming risk of overheating has only partly materialised.

Inflation has been close to but below the 2.5% target for well over three years, and inflation expectations converged with the target from above in summer 2016. Since 2009, there has been a significant current account surplus, which peaked in 2016 at 8% of GDP.

Positive supply shocks, benefits from cross-border economic integration, and prudent macroeconomic policies have been key to this somewhat unusual constellation of economic outcomes. Growth in exports, improvements in terms of trade, and a shift of the international investment position from highly negative at the peak of the crisis to positive at the end of 2016 have raised the equilibrium real exchange rate. It has therefore been possible to accommodate large wage increases in recent years and keep inflation close to target through a sizeable nominal appreciation of the currency. Bottlenecks in the labour market have been mitigated through record importation of labour, which partly explains how the economy could grow significantly in excess of longer-term potential. Finally, monetary policy has been tight, with the nominal policy rate currently at 4.5% and the real policy rate having fluctuated in the 2.5%-3% range since early 2016. This stance was key to bringing inflation expectations down to target and, along with the market-driven nominal appreciation of the króna, has prevented inflation risks from materialising.

The comprehensive controls on capital outflows that were introduced during the crisis were mostly lifted in three major steps in winter 2016/17. Over time, this will bring significant efficiency gains.

However, small, open, and financially integrated economies also face risks associated with large and volatile capital flows, as Iceland learnt the hard way before the crisis. In recent years, the Icelandic authorities have prepared the economy and the financial sector for these risks by building resilience and strengthening financial sector regulation and supervision. The general government deficit that peaked at almost 10% of GDP in 2010 was significantly reduced in the following years and turned into a surplus in 2016. Public and private sector debt has fallen significantly relative to income since the crisis. Foreign exchange reserves are bigger than ever and mostly financed domestically. The banks are well capitalised, with an average leverage ratio of 17% at the end of 2016. They must satisfy requirements concerning a special liquidity coverage ratio and a net stable funding ratio in FX, which significantly limits the risk in the FX part of their balance sheets.

Parliament recently passed legislation enabling the regulation of potential build-up of currency mismatches in the private sector. A special reserve requirement on carry trade-related capital inflows is currently in force, which limits risks stemming from the accumulation of such positions and creates more scope for monetary policy to keep interest rates significantly higher than in the rest of world, as is currently warranted by Iceland's strong relative cyclical position. Finally, macroprudential oversight and tools are being developed and activated.




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