Monetary policy and instruments
The objective and implementation of monetary policy
The objective of monetary policy is price stability. On March 27, 2001, a formal inflation target was adopted, as follows (See the joint declaration of the Government of Iceland and the Central Bank of Iceland):
• The Central Bank aims for an annual rate of inflation, measured as the twelve-month increase in the CPI, which in general will be as close as possible to 2½%.
• If inflation deviates by more than 1½ percentage points from the target, the Central Bank shall be obliged to submit a report to the Government explaining the reason for the deviation, how it intends to respond, and when it expects the inflation target to be reached again. This report shall be made public.
• The Central Bank shall publish inflation forecasts, projecting inflation three years into the future. Forecasts shall be published in the Bank’s Monetary Bulletin. This shall also contain the Bank’s assessment of the main uncertainties pertaining to the inflation forecast. The Bank shall also publish its assessment of the current economic situation and outlook.
Since monetary policy aims at maintaining price stability, it will not be applied in order to achieve other economic targets, such as a balance on the current account or a high level of employment, except insofar as this is consistent with the Bank’s inflation target.
Main monetary policy instruments
The Central Bank implements its monetary policy by managing money market interest rates, primarily through interest rate decisions for its collateral loan agreements with credit institutions, which then affect other interest rates. Yields in the money market also have a strong impact on currency flows and thereby on the exchange rate, and in the long run on domestic demand. Generally speaking, transactions with financial institutions can be classified as regular facilities and other facilities. Transactions between financial institutions and the Central Bank are subject to the Rules on Central Bank of Iceland Facilities for Financial Undertakings, no. 808 of August 22, 2008.
• Current accounts are deposits of the credit institutions’ undisposed assets. These are settlement accounts for netting between deposit institutions and for interbank market trading, including transactions with the Central Bank. Interest rates on these accounts set the floor for overnight interest rates in the interbank market.
• Overnight loans are provided at the request of credit institutions and secured with the same securities that are eligible for collateral loan transactions (see below). Overnight interest rates form the ceiling for overnight interest rates in the interbank market.
• Certificates of deposit are issued with a maturity of 7 days, at the request of credit institutions. They are registered at the Icelandic Securities Depository and with Clearstream. Their function is to counteract temporary surplus liquidity in the banking system. The auction format is fixed-price. Financial institutions can also deposit funds in time deposit accounts bearing the same interest rate.
• Collateral loans are the Central Bank’s main instrument. Auctions of 7-day agreements are held every week. Credit institutions must put up securities that are eligible as collateral, as specified in the Central Bank’s Rules no. 808 of August 22, 2008. Auctions can be fixedprice or auctions where the total amount is announced. Fixed-price auctions have been used so far. The interest rate on collateral loans constitutes the Central Bank’s policy rate.
• Collateral loans, certificates of deposit, and time deposits with periods other than those assumed in regular facilities.
• Currency swap agreements.
• Repurchase agreements with securities that are deemed eligible as financial collateral according to Article 11 of the Rules on Central Bank of Iceland Facilities for Financial Undertakings. The purchases must take place on a regulated securities market.
Required reserves apply to credit institutions that are not dependent on Treasury budget allocations for their operations. The required reserve base comprises deposits, issued securities, and money market instruments. The required reserve ratio is 2% for the part of the required reserve base that is tied for two years or less. The maintenance period is based on the 21st day of each month until the 20th of the following month, and the two-month average reserve must reach the stipulated ratio during the period. Reserve requirements do not apply to foreign branches of Icelandic financial institutions.
Intervention in the foreign exchange market
Foreign exchange market intervention, in keeping with the declaration on the inflation target from 2001, is employed only if the Central Bank considers it necessary in order to promote its inflation target or sees exchange rate fluctuations as a potential threat to financial stability.