The Icelandic central bank needs a new target
By Lars Christensen, Founder & CEO, Markets & Money Advisory, LC@mamoadvisory.com
Last week, I strongly criticized Sedlabanki’s decision to cut its key policy interest rate, since this will just add fuel to what might very well turn out to be an unsustainable ‘boom’.
But while there is no doubt that monetary policy in Iceland needs to be tighter, not easier right now, it’s time to discuss an even more important topic – the monetary policy framework.
My firm belief is that central banks should follow rules rather than conducting policy in an unpredictable, discretionary fashion. Even so, I have very strong reservations about whether Sedlabanki should be targeting inflation.
On a month-to-month or year-to-year basis, inflation is driven by both supply side factors (for example, import prices or productivity) and demand side factors. If it wishes, the central bank can exercise virtually full control over the demand side of the economy, but it has little or no influence over the supply side.
In this light, it is rather foolish to demand that Sedlabanki deliver on a target that it cannot control – at least in the short term. Iceland’s central bank targets 2.5% inflation, as measured by the consumer price index (CPI). However, since Iceland imports most of its consumer goods, inflation as measured by CPI will tend to fluctuate with import prices and the exchange rate.
In principle, Sedlabanki has 100% control over the krona’s exchange rate, but that would require policymakers to react to supply shocks – which seldom makes for sound policy.
A better yardstick – nominal wages
My suggestion would be for Sedlabanki to shift its target to nominal demand in the Icelandic economy. Money supply growth or nominal GDP growth are indicators that approximate this, but both have their problems. I would advocate nominal wage growth as a better yardstick.
In the medium to long term, nominal wage growth would closely mirror the inflation target. Over the short run, however, it would behave differently, and in a way that reduces the risk of boom-bust cycles. Ideally, Sedlabanki should target nominal wage growth as the sum of long-term productivity growth plus the 2.5% inflation target. Assuming 2.5% productivity growth, that would imply a nominal wage target of 5%.
The graph shows these measures since 2011 (the post-crisis period). We see from the consumer price level that Sedlabanki has overshot its inflation target since 2011. But it is even worse – in fact, a lot worse – if we look at the nominal wage level (adjusted for 2.5% annual productivity growth).
This is my point. If we look at CPI, then inflation might very well still be below target on a year-on-year basis. But the demand pressures are much, much more worrying and tell us that a sharp acceleration in inflation could be around the corner.
The real issue is not how Icelandic policymakers should react when the inflation spike comes. Rather, it is how they should change their policy target – preferably as soon as possible.
This article was first published in the Icelandic newspaper Fréttablaðið on May 31 2017. See here (in Icelandic)