The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of Iceland 2006 published on 9 August 2006.
Monetary policy will have to be tightened further to return inflation to the target
The monetary policy framework introduced in 2001 is being put to the test. The objective of the Central Bank is to stabilise consumer price inflation around 2½ per cent, since delivering low, stable inflation is considered to promote good economic performance. However, not only has inflation exceeded the official target since 2004 (by as much as 5½ percentage points recently), but it is also expected to remain above the target for the foreseeable future. Surveys of businesses and households, bond market quotes, forecasts of financial analysts and the Central Bank’s own projections all point to excessive inflation over both the near- and medium term. Although some of these forecasts were recorded some time ago, yield differentials from the bond market indicate that the inflation outlook has worsened considerably in recent months. Hence, the Central Bank needs to raise interest rates substantially so that inflation is brought back to the target. If inflation expectations are allowed to continue drifting upwards, this will jeopardise the wage formation process and increase the sacrifice ratio. The Central Bank needs to re establish the credibility of its commitment to the target through firmer policy and clearer communication. In line with recent Central Bank statements, it would be advisable not to call the thresholds at which reports are required “tolerance limits”, because this seems to have led to a widespread misperception that inflation near the upper limit is acceptable. The government needs to ensure that its agreement with Central Bank on the inflation target is being implemented. If no progress is made in achieving the target, then accountability mechanisms would need to be strengthened.
Longer-term interest rates also need to increase
Although nominal short-term interest rates have been raised substantially -- by 7½ percentage points since mid-2004 -- this has not translated into real lending rates, which remain low despite a recent up-tick. There are several reasons for this, but one possibility is that financial markets do not expect the policy rate to stay high. Clear communication is needed to prevent misperceptions about future interest rate developments. The authorities have introduced a pre-announced schedule for monetary policy meetings that conclude with a public announcement of the Central Bank’s decision regarding its policy rate. Moreover, the Bank’s statements have provided increasingly clear guidance about the likely evolution of policy, although progress has been uneven. These developments are welcome and should continue.
Central Bank inflation forecast
As of July 2006 for the period: Q3 2006 - Q2 2008
Source: Central Bank of Iceland.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded. It contains the OECD assesment and recommendations but not all of the charts included on the above pages.
The complete edition of the Economic Survey of Iceland 2006 is available from:
For further information please contact the Iceland Desk at the OECD Economics Department at email@example.com. The OECD Secretariat's report was prepared by Hannes Suppanz and Peter Tulip under the supervision of Patrick Lenain.