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Iceland Gov: Govt's Plans Mustn't Hurt Centbank's Credibility
04:20 EST / Feb 28
By David Barwick
SYDNEY (MNI) - It is important that the credibility of monetary policy not be negatively affected by potential changes to the governance structure of the Central Bank of Iceland in order to avoid an impact on inflation expectations, Governor Mar Gudmundsson told MNI Monday.
Independent of the communication of possible changes, the real monetary policy stance of the central bank will tighten if economic slack turns into a positive output gap next year as forecast, he said.
Gudmundsson, speaking on the margins of a meeting of central bankers taking place in conjunction with the G20 gathering of finance ministers and monetary authorities, said nevertheless that nominal interest rates in Iceland might possibly decline in the near term.
"On the one hand, inflation is coming down closer to the target, and hopefully inflation expectations will follow suit," he said, which given current nominal interest rates would imply a real tightening.
"And that might happen too fast for the kind of situation we're in, and therefore it is conceivable that nominal rates might even go down in the near term," he said. "It depends on the exchange rate, it depends on inflation."
Gudmundsson continued: "But looking a little further ahead, you have these prospects of all the slack disappearing and turning into a positive output gap, which will call for a tightening of the real policy stance."
Although the mix of relevant elements makes the overall situation "more than a bit uncertain," he said, "what is for sure is that given current forecasts, the real stance is unlikely to be reduced and will, if the forecasts materialize, become higher going forward as the slack in the economy disappears."
The Icelandic government informed Gudmundsson on February 20 - hours before the expiry of the relevant legal deadline and six months before the end of his current five-year term - that it would advertise the position of central bank chief.
"This is a decision that the Finance Minister on behalf of the government has a right to take, according to the rules of the game," Gudmundsson told MNI. "The Minister has been adamant, and said so in public, that this is not because of any lack of confidence or trust in me. The reason given for this decision is that the government is contemplating potential changes to the management structure of the central bank."
It is important that communication regarding the process and its objectives maintain the credibility of the central bank's monetary policy in order to avoid negatively affecting inflation expectations and in turn the stance of monetary policy, said Gudmundsson.
"Depending on the communication in the next few days and weeks, if the markets begin to draw the conclusion that there is some implicit change to either the inflation target or the de facto willingness to use the instruments of monetary policy to achieve the target, then that might affect inflation expectations and market expectations, and that in turn will always have an effect on monetary policy," he said. "There is speculation to that effect but there are no statements that I am aware of from the Finance Minister that support that."
The Icelandic central bank since 2009 has had a governor and a deputy governor, with monetary policy decisions taken by an MPC that includes both these officials as well as the chief economist of the bank and two external members.
According to Gudmundsson, the government may elect to return to the previous system of three governors, or introduce some other model.
In any case, he said, "they felt that their degree of freedom in making such changes would be reduced if my term was extended automatically."
To be sure, he noted, the government and in particular the Finance Minister have denied any intention to curtail the central bank's independence.
Nonetheless, there is now some uncertainty about what will take place and the implications for the central bank's inflation-fighting mandate and its willingness to use the tools at its disposal to fulfil that, he said.
"I have no quarrel with the government contemplating different models for the governance of the central bank. But that has to be a good process, a well prepared process, and at the end of the day it is the parliament that has the final word," Gudmundsson said. "But I think it's important to find ways to relieve the kind of short-term uncertainty associated with this and to make an effort to avoid negatively affecting the credibility of and trust in the central bank and its monetary policy process."
Asked whether he would potentially be willing to remain at the bank as one of several governors, Gudmundsson, who had been willing to start a second term under the current set-up, replied:
"The question for me is not whether I would be willing to be a governor, but rather, will I be willing to apply for the position of governor or possibly of chairman of the board of governors if there is a change to the system? That is something that is impossible for me to say at this point and will depend on the credibility of the process and any potential new framework."
Still, he added, "if the process is credible, if I can believe in it, then I might consider doing that."
Turning again to the economy, Gudmundsson noted that despite the fact that the central bank has been bulking up its foreign reserves, the krona continues to appreciate on the back of strong net exports including tourism, bringing inflation down "rather rapidly recently," he noted.
"We are hoping that we will be very near to our inflation target or even hit it this month," he said. "And our prediction is that we will then stay near the target towards the end of this year. But then, inflationary pressures might begin to increase again because of the slack in the economy turning into a positive output gap. But there are uncertainties about that, for sure."
As to the economic recovery, Gudmundsson estimated that Iceland's GDP grew by 3% in 2013 and would slow to 2.6% this year. Growth is then forecast to accelerate in 2015 to 3.7% but slide back to 3% in 2016.
With respect to the Prime Minister's recent comment that Icelandic unemployment - already a mere 4-4.5% - could decline to as low as 2%, Gudmundsson said that such a scenario might be possible "sometime in the future" but would require structural reforms that increase the effectiveness and flexibility of the labour market.
"In the near term, the unemployment rate is forecast to go below 4%," he said. "Our prediction is that the slack in the economy might be disappearing towards the end of this year and the beginning of next. The unemployment rate will then gradually decline further and hit 3.5% in 2016."
All in all, the economic picture in Iceland five years after the overblown banking sector imploded is a good one, he said: "We have a strong economy, a strong external sector, appreciating pressures on the currency, an accumulation of foreign exchange reserves and inflation hitting the target. That is not so bad!"
On the "very challenging task" of lifting capital controls imposed in the wake of the crisis, it remains impossible to offer any sort of timeline, Gudmundsson said.
"There is not only an issue of finding a solution in technical terms that would allow the old banks to distribute to creditors. The solution also has to be comfortable to the authorities in terms of being compatible with our financial stability and balance of payments," he elaborated.
He continued: "And that is why this might take a while, but once you have a solution to this and other measures are taken to relieve the foreseeable pressure on the balance of payments in the next few years due to the heavy repayment schedule on contractual foreign currency denominated foreign debt, then the rest might move somewhat more quickly, because the underlying conditions for lifting the controls are better than a few years ago, since we have a current account surplus, we are very close to a surplus on the central government, we have a good forex reserves cover, the economy is growing relatively strongly and the domestic imbalances in the economy in terms of inflation are becoming smaller."