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What is the appropriate conduct of monetary policy?
As noted, the new monetary policy regime should help limit the build up of imbalances over the near term. Following the adoption of inflation targeting in 2001, the Central Bank succeeded in bringing both 12 month consumer price increases and inflation expectations (as implicitly gauged by bond investors) down to the official objective of 2½ per cent. However, with the recent pick up in inflation, expectations have also risen, drifting up to the Central Bank’s upper tolerance limit of 4%. This suggests that the new framework’s credibility is not yet fully established, which is not unusual in view of its recent adoption. Anchoring inflation expectations to the target is particularly important because the March 2004 multi year wage agreements in the private sector were based on the twin assumptions of inflation near the official objective and similar settlements in the public sector and can be reopened in late 2005 if these assumptions are not satisfied. The Central Bank has strived to enhance confidence in and understanding of the new monetary policy framework through outreach activities and its publications, but there would seem to be room for further strengthening it. In particular:
As the recent hike in the inflation rate reflected not only international oil price developments but also domestic demand pressures, the Central Bank appropriately began to raise its policy interest rate in mid 2004. By year end the policy rate was almost 3 percentage points higher than it had been in the spring, though, with the rise in inflation expectations, the rise in real interest rates has been much smaller. In addition, developments in financial markets counteracted the Bank’s initial tightening moves. Stock market and property prices have surged, and — more recently — commercial banks and subsequently the public Housing Financing Fund (HFF) have offered mortgage loans at much lower interest rates than hitherto. The banks’ entry into the mortgage market, which facilitates equity withdrawal, is adding to household demand and inflation. Similarly, the latest relaxation of HFF lending limits risks further stimulating demand in the housing market. Finally, the recently legislated reductions in personal income taxes could begin to stimulate spending even before they have been fully implemented. In these circumstances:
How should fiscal policy contribute to maintaining economic stability?
A tight stance of fiscal policy during the investment boom would alleviate the burden on monetary policy to safeguard price stability without the need for excessively high interest rates, which are already putting upward pressure on the real exchange rate and squeezing the exposed sector of the economy. Regrettably, in 2003, when economic activity rebounded, the general government budget moved into substantial deficit, reflecting fiscal loosening due to a number of discretionary spending measures as well as recurring expenditure overruns. Helped again by stronger than assumed economic growth, the budget appears to have returned to broad balance in 2004. While fiscal tightening — in particular a cutback in public investment — contributed, expenditure restraint seems to have fallen short of intentions. Nonetheless, the withdrawal of the sharp fiscal stimulus imparted in 2003 is welcome. But it needs to be sustained so long as excess demand conditions prevail. The latest budget calls for general government surpluses in 2005 and 2006. However, these surpluses — both in actual and cyclically adjusted terms — are projected to be modest compared to those recorded during the overheating period of the late 1990s, which were 1 to 2 percentage points of GDP higher. The tax cuts for 2005 07 will slow fiscal tightening in the near term and, in the absence of further measures, are projected to bring it nearly to a halt in 2006, just when the construction projects peak. Hence:
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Now that the tax cuts have been passed, the authorities should aim at budget surpluses higher than those currently planned to ensure a better policy mix, by rigorously avoiding spending overruns (especially in the form of high public sector pay rises), implementing additional spending restraint and reducing tax expenditures favouring the housing sector.
With the exception of a brief period in the 1990s when radical austerity policies eliminated the budget deficit, expenditure growth has been rapid. Moreover, despite reforms to the fiscal framework, especially the introduction of “frame budgeting” (setting expenditure ceilings), and, more recently, of medium term budget projections, public spending has tended to exceed not only the “frames” but also the ultimately voted (and usually higher) authorisations. Sometimes, as in 2003, supplementary budgets raise expenditure during the year; yet even discounting that, deviations from budgeted levels have remained substantial. According to the National Audit Office, a large number of government bodies exceed the permitted annual budget overrun (which is limited by regulation), and some have done so for many years. Apart from complicating the use of fiscal policy for economic stabilisation purposes, this puts upward pressure on taxation. Whereas from 1978 to 2003 the public expenditure to GDP ratio rose by about 4 percentage points in the OECD area, it rose by 16 points in Iceland, and the revenue to GDP ratio increased accordingly. Such a steep rise in tax pressure is bound to have a negative impact on the growth of output and real income mainly through the associated higher marginal tax rates which distort incentives to save, work and invest. In this perspective, the recent tax cuts are likely to have favourable supply-side effects on economic performance. In order to address these issues:
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