Globalization and the Icelandic Rollercoaster Ben Hunt

The Question Will globalization speed the Icelandic roller coaster, or can the right policy frameworks smooth the ride?

The Icelandic Rollercoaster: Macroeconomic Volatility Real GDP growth more volatile than other open non- European IT countries Also more volatile than in European IT countries

The Icelandic Rollercoaster: Macroeconomic Volatility Inflation level and volatility much higher than in non-European IT countries The same goes for European IT countries

The Icelandic Rollercoaster: Macroeconomic Volatility Short-term interest rates higher and more variable than in non- European IT countries The same goes for European IT countries

The Icelandic Rollercoaster: Macroeconomic Volatility Exchange rate variability is not much different from non- European IT countries Exchange rate is more variable than in European IT countries

What Drives the Rollercoaster Relative to the size of the economy, the economic shocks are large The degree of openness amplifies the impact of shocks – flows of capital and goods

Will Globalization Speed the Rollercoaster? Globalization implies greater openness to both capital and goods International capital flows make it more difficult for monetary policy to control domestic credit expansion and thus domestic demand and inflation Increased openness to international goods markets also implies less control over domestic prices and thus demand and inflation

Policy Options for Increased Macroeconomic Stability Euro adoption - given large portion of trade with Euro area Improvements to existing policy frameworks

Euro Adoption Analysis of cost and benefits in Iceland’s case necessary Potentially benefits come from: –reduction in country-specific risk premium –increase trade because of lower transactions costs –increased FDI Potential costs come from foregoing independent monetary policy and shock absorbing role of flexible exchange rate

In Iceland Benefits Could be Smaller Benefits may be smaller than in other European countries because of: low risk premium; increasing importance of emerging Asia in trade; portion of exports directed to global markets; and no shortage of FDI in Iceland.

But Costs Could Also be Lower Cost may be lower than in other European countries because of: long-term indexed mortgage contracts limit effectiveness of monetary policy instrument; and share of imports in consumption bundle limits shock absorbing role of flexible exchange rate.

Euro Adoption Needs Careful Analysis If the objective is increase output and inflation stability, it is far form clear that Euro adoption would be the answer Careful analytic work would be exceedingly helpful to inform the discussion of potential cost and benefits

Improving the Existing Frameworks Can the inflation-targeting framework be more effective Can the fiscal-policy framework provide greater macroeconomic stabilization

The Inflation-Targeting Framework Standard deviation of CPI inflation from target Standard deviation of output from potential Iceland New Zealand Canada U.K. Efficient Monetary Policy Frontiers

The Inflation-Targeting Framework Considerable improvement has been made to transparency and communication The policy instrument itself could be made more effective Changes to the targeted index could potentially be helpful anchor expectations

Increasing the Effectiveness of the Policy Instrument Mortgage market – no need for publicly-owned HFF Avoid the competition that undermined monetary policy effectiveness in the current cycle Lead to product innovations that could make household debt service more responsive to the policy rate (also lower mortgage rates for households) Less variability in interest rates would limit destabilizing impact of international capital flows

Targeted Price Index Examine alternative indexes –highly correlated with headline CPI in medium term but less volatile in near-term Change only once headline CPI re-anchored at target Could help stimulate change in structure of available mortgage products A less variable target index would lead to lower interest rate variability

Fiscal Policy Framework Better investment project planning Rules-based fiscal framework to ensure strongly countercyclical fiscal policy From industrial-country perspective, fiscal policy in Iceland has been well managed, but bar needs to be higher to deal with challenges

Rules-Based Fiscal Framework The Effects of a Rules-Based Fiscal Policy Inflation variability Output variability

Rules-Based Fiscal Framework Interest Rate vs. Exchange Rate Interest rate variability Exchange rate variability

Summary Macroeconomic volatility in Iceland is high and globalization pressures likely to increase it Policy options to increase stability: –Euro adoption –Further framework enhancements

Summary Not clear that Euro adoption would increase macro stability – careful analytical works needs to be done Inflation-targeting framework –Has evolved to better anchor expectations –Instrument needs to be more effective and HFF reform necessary step –Less volatile target index would be helpful

Summary Better investment project planning would help reduce magnitude of key domestic shocks Formal rules–based fiscal framework to increase stability Although fiscal policy has been well managed, magnitude of challenges requires more

Summary

Lessons for Other Countries Policy instrument needs to be as effective as possible Reduce amplitude of business cycle Policy actions to achieve these will be country specific

The Importance of the Shocks Small estimated models of several open economies can be used to illustrate the importance of the shocks Assuming monetary policy is operated to achieve the lowest possible variability in inflation and output, Iceland faces a daunting challenge

Elements of Rules-Based Fiscal Framework Coalition agreements spelling out specific spending objectives as well as commitment to stabilization requirements Nominal spending targets based on inflation target (clear joint ownership) Rules to prevent expenditure slippages – both central and local

Elements of Rules-Based Fiscal Framework Use of external forecast for budgeting Stakeholder committees to Rules to prevent expenditure slippages – both central and local