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Table 4. The macroeconomic impact of the construction of power plants and aluminium smelters

Table 4. The macroeconomic impact of the construction of power plants and aluminium smelters

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Economic performance and outlook



35



commence production in 2007, as well as related hydro-power and infrastructure

investments; and the enlargement of an existing smelter in the vicinity of the capital in two steps, with new production capacities available in 2005 and 2009.

According to official estimates of their broader economic effects, total fixed capital

formation would be boosted by half in the middle of the decade and by a quarter

on average until 2010. Economic growth could reach 5 to 7 per cent in 2005-06,

and the unemployment rate might drop to below 1 per cent. The current account

could deteriorate by 6½ per cent of GDP during the construction period, adding

15 percentage points to the already high foreign debt, and the 4 per cent tolerance

limit associated with the inflation target will probably be exceeded unless offsetting

measures are undertaken. A liberal immigration policy would reduce labour-market

and hence inflation pressures, but maintenance of economic stability will be above

all the task of monetary and fiscal policies. The macroeconomic policy settings that

could contribute to continued favourable economic performance are reviewed in

the next chapter.



© OECD 2003



II.



Macroeconomic policies



Macroeconomic management has helped overcome the domestic and

external imbalances that developed during the period of overheating in the

late 1990s. The floating of the currency and switch to an inflation-targeting framework in March 2001 has been successful to date. Although the exchange rate temporarily undershot its equilibrium value, the resulting redirection of activity

towards exports contributed to the restoration of external balance. And, while

price performance deteriorated early in the new regime, the weakening in activity

generated in part through a tight monetary stance has helped to bring inflation

back to its target. Given the substantial budget surpluses that were realised in the

late 1990s, a government deficit has been avoided. The fact that the fiscal stance

became slightly restrictive last year has helped and resulted in a more appropriate

policy mix. At the current juncture, the difficult task facing policymakers is to balance a modest degree of near-term economic slack against the strong likelihood of a

sharp acceleration in growth from next year onwards.

Monetary policy

A new regime was adopted in 2001 to better anchor inflation and the external balance

Since the early 1990s, monetary policy has been oriented towards maintaining low inflation, and through early 2001 the nominal anchor had been a nominal exchange rate target. Originally, the exchange rate was kept within a narrow

band (2¼ per cent) around the target, but this band was widened to 6 per cent

in 1995 and again to 9 per cent in February 2000. These widenings reflected, in

part, the shortcomings of an exchange-rate target with the increase in capital

mobility that had accompanied financial market liberalisation in the 1990s. But the

widening in 2000 also stemmed from the challenges for monetary policy posed by

an overheating economy with a current account deficit approaching 10 per cent of

GDP. Maintenance of the exchange-rate target at that time was both incompatible

with internal balance and a contributing factor in the mounting burden of foreigncurrency-denominated debt. Following the widening of the target range, the nominal exchange rate depreciated nearly 10 per cent over the course of 2000

(Figure 7). Inflation rose significantly in 2000, to 5 per cent, and the economy

remained overheated in early 2001.



© OECD 2003



OECD Economic Surveys: Iceland



38



Figure 7. Exchange rate developments

Monthly average of exchange rate index

Index



Index



145



145



140



140



135



135



130



130



125



125

Lower band of target range



120



120

Central rate



115

110



115

110



Upper band of target range



105

100



105

1997



1998



1999



2000



2001



2002



100



Source: Central Bank of Iceland.



Against this backdrop, the government and the Central Bank announced

their decision to adopt inflation targeting in March 2001. The Central Bank’s objective is to target an inflation rate of 2½ per cent, as measured by the twelve-month

change in the Consumer Price Index (CPI), with a tolerance band around this target

(see Box 1). In conjunction with the new regime, the Central Bank was granted

increased independence. These moves bring the monetary regime from a position

of low independence (relative to other OECD member countries) to one more similar

to those facing other central banks as well as more conducive to price stability. Box 1

provides further information on the inflation–targeting regime and a comparison with

other countries’ experience.

Inflation expectations drifted up in the first months of the new regime

The immediate effect of abandoning the exchange-rate target was a sharp

drop in the value of the krona; the exchange rate fell 16 per cent between February and June (on a monthly average basis), then strengthened briefly. The depreciation led to an increase in inflation expectations, which averaged nearly 5 per cent

over a five-year horizon in May and June 2001 (Figure 8). This level suggested that

financial market participants anticipated that the upper bound of the inflation target range would be breached, on average, over this horizon. In addition to the

effect of the falling value of the currency, incoming data on inflation showed an

acceleration: in the six months ending in June, the CPI increased nearly 11 per cent



© OECD 2003



Macroeconomic policies



Box 1.



39



Inflation targeting in Iceland: the framework

and an early assessment



On 27 March 2001 the government announced that monetary policy would

henceforth follow an inflation-targeting framework with a goal of price stability.

Other economic targets, such as the balance on current account or full employment, are subsidiary and are to be pursued only when such goals facilitate

achievement of price stability. The ultimate target for CPI growth is 2½ per cent,

with a 1½ percentage point tolerance band. In order to allow for a gradual downward adjustment to the targeted inflation rate, upper branches of the tolerance

band of 3½ percentage points and 2 percentage points were set for 2001 and 2002,

respectively. The Central Bank began to publish a quarterly inflation forecast with

an explanation of the factors influencing price developments in its Monetary Bulletin, with projections two years into the future. Any breach of the tolerance band

around the target would trigger a special report to the government detailing the

planned corrective action.

Under the new regime, the Central Bank implements monetary policy through

adjustments of money-market interest rates, which impact demand through

effects on the exchange rate and interest rates across the term structure. The primary instrument is the rate on 14-day repurchase agreements. In addition, a floor

on overnight rates is set through the rate on credit institutions’ current accounts

(deposits of undisposed assets) with the Central Bank. An upper ceiling on the

overnight rate is implemented through the overnight rate on loans from the

Central Bank.

Figure 8 presents the twelve-month change in the Consumer Price Index

along with the target and tolerance bands since 2000 and inflation expectations

over the next five years as indicated by the spread between indexed and nominal

yields on government bonds at that maturity. The shift to inflation targeting and

greater independence for the Central Bank did not immediately confer credibility

on the new regime. Instead, in contrast to experience abroad (Johnson, 2002),

inflation expectations initially rose and indicated that at the outset agents were

discounting further price increases outside the long-run target range (whose

upper limit is 4 per cent per year), albeit within the temporary range set for the

first two years of the regime. These expectations appear to have been driven

largely by the weakness in the krona. They began to moderate as the current

account deficit narrowed. The Central Bank maintained a restrictive level of real

short-term rates during 2001 (see below), and the currency turned a corner late

that year. It is also noteworthy that inflation breached the target band early in the

new regime, but the consistently restrictive policy stance and the later strengthening in the exchange rate – combined with the Central Bank’s firm position that

the breach reflected past developments and should prove temporary – meant

that the new regime’s credibility was not impaired.

It is also instructive to compare Iceland’s limited experience with that of other

inflation targeting regimes. Twenty-two countries adopted inflation targeting

between 1990 and June 2001. (Spain and Finland dropped out of the league of

inflation targeters upon joining the European Monetary Union.) It is clear that Iceland



© OECD 2003



OECD Economic Surveys: Iceland



40



Box 1.



Inflation targeting in Iceland: the framework

and an early assessment (cont.)



is among the set of countries that adopted inflation targeting after already achieving reasonably low levels of inflation, and hence that the regime should be

viewed as a method to institutionalise a previous move toward price stability

(Table 5). It is also clear that a number of other countries have adopted inflation

targeting as a means to achieve price stability after the previous regime had failed

on this front. Seven of the inflation targeting countries currently appear to be in a

transition phase with inflation higher than their long-run goals (Brazil, Colombia,

the Czech Republic, Hungary, Mexico, Poland and South Africa). Among the

remaining 12 countries, excluding Iceland, the average inflation target is 2.9 per

cent and the target range is ±1.5 percentage points (Schmidt-Hebbel and

Tapias, 2002); both data points are very similar to Iceland’s regime, which has just

a slightly lower inflation target.

Iceland is a very small open economy and hence a useful comparison might

be with New Zealand, the first country to move formally to inflation targeting.

Overall, the regime in New Zealand has been a success (as is true elsewhere). In

September of last year, a new target inflation range (1 to 3 per cent, versus the previous 0 to 3 per cent) was adopted in New Zealand, and at the same time the midpoint of the range was de-emphasised, so that inflation readings within the target

range above or below the mid-point are no longer viewed as requiring policy

adjustments. Iceland has a slightly broader target range with a higher mid-point

(1 to 4 per cent). This may be preferable for Iceland: the recent past has demonstrated that external shocks can have significant exchange-rate effects, leading to

sizeable and temporary inflation fluctuations. Moreover, the somewhat higher

mid-point may be beneficial, despite the fact that deflation in Iceland is not even

considered a remote possibility in the foreseeable future.

One change that may enhance transparency would be for Iceland to schedule

regular policy meetings and announce decisions at such times. Currently, Iceland is

the only inflation targeter that does not have such a schedule (Schmidt-Hebbel and

Tapias, 2002). Regular announcements can improve communication during periods

when policy changes are not occurring. After all, a decision to leave rates unchanged

is driven by the outlook and has important implications for prices and activity.



at an annual rate, nearly three times the pace over the twelve months of 2000.

However, the slope of the term structure, with nominal short-term rates in excess

of 11 per cent in June while yields on 5-year Treasury notes were yielding a bit less

than 10 per cent, indicated that market participants anticipated a downward drift

in inflation and nominal interest rates and that much of the slippage relative to

the inflation target was expected to be relatively short-lived.

The implementation of the new regime was accompanied by a cut in the

short-term policy interest rate (the repurchase or repo rate) of ẵ percentage point,



â OECD 2003



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