Ásgeir Jónsson, governor of the Central Bank of Iceland, speaks to Global Finance about why he started hiking rates so soon and why he feels vindicated now that other central banks are following in his footsteps.
“Central bank governors in this country have never been popular,” says Ásgeir Jónsson, governor since August 2019 of Seðlabanki Íslands, Iceland’s central bank, and the only central banker in this year’s Report Cards to be awarded an A+.
The small island, nestled between Scandinavia and North America, has endured its fair share of economic shocks, which has forced the Sedlabanki to take drastic and unpopular actions in the past.
The 2008-2011 financial shock triggered a collapse in Iceland’s economy, three of its biggest privately owned commercial banks and its currency, the krona. Inflation soared from below 4% in late 2007 to 18% in early 2009.
The Sedlabanki responded by drastically hiking the effective policy rate, which peaked at 18% in early 2009 before falling back down to 5.5%. It is a period in Iceland’s economic history that Icelanders and Jónsson, who was then chief economist and head of research at Kaupthing Bank (later Arion Bank), won’t forget any time soon.
With the 2008 economic meltdown and high inflation from that period still fresh in its mind, in May 2021, Iceland’s central bank became the first in the West to start tightening monetary policy, following steep rate cuts during the pandemic. The bank’s key policy rate increased by two percentage points to 2.75%, bringing it back to pre-pandemic levels.
Global Finance: What prompted you to start hiking rates in May last year, when other central banks held off as they thought inflation was “transitory”?
Ásgeir Jónsson: The high inflation of the 1980s, 1990s and the 2008 financial shock when the economy collapsed is still within the living memory of most Icelanders. We are a small, open economy and really do not believe in transitory inflationary shocks, as the consequence of delayed action is much more severe than in the larger economies, given how rapidly small systems can destabilize through excessive credit creation, financial inflows and currency market volatility.
Our experience has taught us to be vigilant in keeping the economy stable and inflation within bounds, as the cost of mistakes is very large. In the spring of 2021, we saw all the usual signs on the wall of rising cost pressures, especially from abroad. Also, the labor market recovered quite rapidly. It was a sharp recovery.
GF: Why do you think other Western central banks did not believe inflation was a real problem sooner?
Jónsson: There are two reasons why central banks underestimated inflation. They overestimated how slowly aggregate supply would recover after Covid, especially in the face of the changed composition of the demand. Second, given that they endured very long periods of depressed inflation, they overlooked the signs very early on of increased cost pressures. They were a little complacent. However, given that we import all our durable goods, we were keenly aware of the broken supply chains and rising international prices. German factories started to raise prices very rapidly. At the same time, the price of our merchandize exports rose, thus there was a great expansion in our foreign sector with both imports and exports expanding very rapidly, which is always the harbinger of an economic expansion and inflation.
GF: How much debate was there within the central bank’s Monetary Policy Committee about hiking interest rates so soon?
Jónsson: There wasn’t that much debate. The committee was unanimous, although at that point there were still concerns about the impact of new strains of Covid-19. However, our decision to raise rates immediately met with harsh criticism in the media. People were saying that we were paranoid, unprofessional. They kept looking at big central banks like the Fed or the European Central Bank saying, “They think inflation is transitory. You are just Icelandic hillbillies.”
Unlike the rest of Europe, Iceland never got into quantitative easing or negative interest rates. Given our demographics and economic fundamentals, our natural rate of interest has been much higher than that of Europe, and thus a zero lower bound on nominal rates was never a problem. It is of course natural that we face the question from the public, the business sector and labor unions on why we could not have zero or negative policy rates like they had in Europe. What we always tried to point out is that Iceland is a very fast-growing economy, which is why the real interest rate is much higher than in Europe. [At the central bank’s last meeting In August, the key interest rate was raised by 0.75% to 5.5%, one of the highest rates in Western Europe.]
Let's put this into perspective. The median age of Iceland’s population is 35. Our birth rate is high. We import a lot of labor from Eastern Europe. We have abundant natural resources and sources of renewable energy. All this translates into fast growth and demand for both labor and capital and relatively tight monetary policy.
So, we were quite pleased when we started to see our approach adopted by other central banks. Given our relationship to the United States—Iceland’s economy is 1,000 times smaller than the US’s—it was important for us to see the Fed embark on an aggressive hiking cycle. It is the only central bank that has the power to quell international inflation. Having been criticized for our approach, for me it was a relief. Also, given that Iceland is a price taker on international markets, we are bound to import inflation from abroad should it persist. Thus, we need to see action from the larger central banks.
With other countries raising interest rates, it also meant we were less likely to attract “hot” money from hedge funds looking for higher yields. It was important for us to not see Iceland standing out of line in terms of nominal interest rate levels.
GF: So, more than 12 months on, how does the media and Icelanders perceive the central bank’s actions?
Jónsson: Our approach has created a lot of pain for the public, but I think that in general there is a greater understanding and belief in what we are trying to achieve. We are seeing the [positive] effects from our policy. After the war in Ukraine started, we saw an acceleration in inflation. We took an aggressive approach and introduced three steep hikes [75 basis points to 100 bps] in rates in a row. We were afraid that inflation expectations would become de-anchored, so we responded accordingly.
The last inflation numbers were comforting. Inflation is falling. Looking at the harmonized price index, we have the lowest inflation in Europe behind Switzerland. [The Harmonised Index of Consumer Prices in June 2022 was 9.6% in the EU and 8.2% in Germany, whereas the price increase was 7.0% in Norway, 5.4% in Iceland and 3.2% in Switzerland.] That is because of the early action we took. Our forecast that inflation would peak at 11% later this year now looks overly pessimistic. We hope that inflation has peaked.
One other reason for our aggressive approach was the pending general wage negotiations with the labor unions. There is a history of unions gathering in one place to negotiate three-year wage contracts in an economywide setting. One of the main reasons we decided we had to act quickly and decisively was to give unions a signal that inflation was going down next year, so when they sit down to make these new wage agreements they will not factor in inflation.
GF: Do you anticipate further rate hikes before the end of the year?
Jónsson: We are now seeing the signs of early rate hikes having an effect. Since we acted so early and decisively, we hope that we can afford to take smaller steps soon. The Monetary Policy Committee is meeting again in early October. We’ll see. We are now waiting for verifiable signs that our actions are having an impact. We want to see inflation continue to go down.
During Covid-19, Icelanders accumulated large amounts savings. But this summer, they went all out and started spending a great deal of money. Hotels were fully booked by tourists. Summer saw a huge increase in revenue. Our currency did not depreciate due to domestic consumption. What will happen moving forward? Will people quieten down now they’ve been able to spend their savings, or will it continue?
I think Icelanders understand it is important to keep control of the economy. The consequences for a small economy to lose control of inflation can be quite devastating.
GF: You’ve stated that the future of monetary policy lies in the expansion of the policy toolbox. Other than interest rates, what are those other tools in the toolbox?
Jónsson: Four to five months after I became governor of the central bank in 2019, we merged the central bank and the Financial Supervisory Authority (FSA). What we have been trying to prevent is for a boom in the real economy to translate into a financial boom. The new legislation gave us a sweeping mandate to put in place tighter controls on lending. We have imposed capital adequacy ratios exceeding 20%, which are much higher than the rest of Europe. We’ve not only been aggressive in hiking rates, but also in trying to contain a boom in lending by applying borrower-based measures limiting leverage and burden of payment.
In a small, open economy, we must watch out for deposit creation, which increases money supply and impacts the currency market. Our FSA mandate is just another tool that helps us keep control of lending and deposit creation. We also have huge FX reserves, which we can used to maintain stability in our balance of payments. Iceland is one of the smallest currency areas in the world with independent monetary policy, and we must look to every tool in our box to maintain sovereign control of our markets and economic system. That is the challenge of being small. You must act quickly, but at the same being small means that you can get quick rewards.