Promoting effective monetary policy and financial stability

Abstract

Like other small, open economies with independent currencies, Iceland has long struggled with balancing its policy objectives within the context of the impossible trinity – exchange rate stability, monetary independence and capital mobility. Even after the move to inflation targeting, monetary policy failed to stave off the over-heating economy in the run-up to the 2008 crisis, and weak financial regulation enabled the destabilising expansion of the banking system. The subsequent fall in the exchange rate caused great pain for Icelandic households and businesses, but also has paved the way for Iceland to work its way out of the recession. The restrictions on capital outflows helped Iceland to regain exchange-rate stability during the crisis, but they risk causing distortions, and ensuring their orderly removal will be Iceland’s key policy challenge in the years ahead. When capital mobility is restored, sound monetary policy and prudential supervision and regulation will be essential. Policies to reduce exchange rate volatility may help anchor inflation expectations, but their scope is limited. Strong prudential supervision and regulation are instrumental for enhancing financial stability and, by discouraging the build-up of financial imbalances, macro-prudential policies hold some promise of augmenting the effectiveness of traditional monetary and fiscal policies.