MONETARY POLICY COMMITTEE REPORT TO PARLIAMENT

MONETARY POLICY COMMITTEE REPORT TO PARLIAMENT 2015 1 Monetary Policy Committee report to Parliament 1

Monetary Policy Committee report to Parliament 2

Monetary Policy Committee report to Parliament 7 July 2015 The Act on the Central Bank of Iceland stipulates that the Monetary Policy Committee (MPC) of the Central Bank of Iceland shall submit to Parliament (Alþingi) a report on its activities twice a year and that the contents of the report shall be discussed in the Parliamentary committee of the Speaker s choosing. The Act requires that the MPC meet at least eight times each year. Since the last Report was sent to Parliament, the Committee has held four regular meetings, most recently on 10 June 2015. The following report discusses the work of the Committee between January and June 2015. Table 1. Central Bank of Iceland interest rates 2015 (%) Rate on Col- Over- Current 7-day lateral night account term lending lending Date rate deposit rate rate 10 June 4,75 5,00 5,75 6,75 13 May 4,25 4,50 5,25 6,25 18 March 4,25 4,50 5,25 6,25 4 February 4,25 4,50 5,25 6,25 Monetary policy formulation According to the Act on the Central Bank of Iceland, the Central Bank s principal objective is to promote price stability. This objective is further described in the joint declaration issued by the Bank and the Icelandic Government on 27 March 2001 as an inflation target of 2½%. Furthermore, the Act stipulates that the Central Bank shall promote the implementation of the economic policy of the Government as long as it does not consider this policy inconsistent with its main objective of price stability. The Bank shall also promote financial stability. By law, the MPC takes decisions on the application of the Bank s monetary policy instruments, which are its interest rates, its transactions with credit institutions other than last-resort loans, reserve requirements, and foreign exchange market transactions aimed at affecting the exchange rate of the króna. The decisions of the MPC shall be based on a thorough and careful assessment of developments and prospects for the economy, monetary policy, and financial stability. In implementing monetary policy, the MPC bases its decisions in part on an analysis of current economic conditions and the outlook for the economy as presented in the Bank s Monetary Bulletin. The MPC s statements and minutes, enclosed with this report, contain the arguments for the Committee s decisions. Developments from January to June 2015 At its June meeting, the Monetary Policy Committee (MPC) of the Central Bank of Iceland decided to raise the Bank s interest rates by 0.5 percentage points. At that time, the Bank s interest rates had been unchanged since the beginning of the year, after having been lowered by 0.75 percentage points in the latter half of 2014. At the end of Chart 1 Central Bank of Iceland interest rates and short-term market interest rates Daily data 1 January 2010-30 June 2015 % 12 10 8 6 4 2 2010 2011 2012 2013 2014 15 Overnight lending rate Collateralised lending rate Maximum rate on 28-day CDs Rate on 7-day term deposits Rate on 1-month term deposits Overnight interbank rate Current account rate Monetary Policy Committee report to Parliament 3

% 4 3 2 1 0-1 -2-3 % 12 10 8 6 4 2 0 Chart 3 Bond yields Daily data 2 January 2009-30 June 2015 2009 2010 RIKB 16 1013 RIKB 19 0226 RIKB 25 0612 2011 Source: Central Bank of Iceland. Chart 4 2012 2013 HFF 150224 HFF 150434 HFF 150644 2014 15 Exchange rate and volatility of the króna Daily data 4 January 2010-30 June 2015 Index Volatility (%) 190 0.6 200 210 220 Chart 2 Real Central Bank of Iceland interest rates 1 January 2010 - June 2015 2010 2011 2012 2013 2014 15 Real Central Bank of Iceland interest rate in terms of twelve-month inflation Real Central Bank of Iceland interest rate in terms of various measures of inflation and inflation expectations² 1. From 2010 to May 2014, the nominal policy rate was the average of the current account rate and the maximum rate on 28-day CDs. From May 2014, the policy rate has been the seven-day term deposit rate. 2. Until January 2012, according to twelve-month inflation, one-year business inflation expectations, one-year household inflation expectations, the one-year breakeven inflation rate, and the Central Bank forecast of twelve-month inflation four quarters ahead. From February 2012 onwards, according to the above criteria, plus one-year market inflation expectations based on a quarterly Central Bank survey. Sources: Gallup, Statistics Iceland, Central Bank of Iceland. 0.5 0.4 0.3 June 2015, the Bank s key rate the rate on seven-day term deposits was 5%, up from 4.5% at the beginning of the year. 1 Although the Bank s nominal interest rates have been raised, the monetary stance has eased since the beginning of the year, when the MPC submitted its last report to Parliament. In terms of the average of various measures of inflation and inflation expectations, the Bank s real rate was 1.7% as of end-june and 3.4% in terms of past twelvemonth inflation, or 0.2-0.5 percentage points lower than at year-end 2014. Yields on indexed Treasury and Housing Financing Fund bonds have developed broadly in line with the Bank s real rate, whereas real yields on longer nominal bonds are almost unchanged. The long-term breakeven inflation rate in the bond market has risen by approximately 1½ percentage points year-to-date. The exchange rate of the króna has held relatively stable in trade-weighted terms so far this year, as it did in 2014. The króna has appreciated year-to-date by 1.4% in trade-weighted terms and by 4.8% against the euro. However, it has weakened by 3½% against the US dollar since the beginning of the year, and by 14.2% since mid-2014, which is in line with movements in other developed countries exchange rates against the dollar. The Central Bank has continued to purchase currency in the foreign exchange market. In the first half of 2015, the Bank bought currency from market makers in the amount of 81.4 b.kr. (548 million euros), which is double the amount bought over the same period in 2014. Inflation has risen since the MPC submitted its last report to Parliament. Twelve-month inflation in terms of the CPI measured 1.5% in June, up from 0.8% in December 2014. Inflation has been at or below the Central Bank s inflation target for seventeen consecutive months. Underlying twelve-month inflation as measured by core index 3 (which, in addition to the effects of indirect taxes, excludes volatile food items, petrol, public services, and real mortgage interest expense) was also 1.5% in June, having increased slightly since December. The main driver of inflation in the recent term has been the rise in house prices. The rise in the housing component therefore accounts to a large degree for the rise in inflation in the first half of the year, although the price of private services also rose somewhat. 2 Excluding the housing component, twelve-month inflation measured 0.2% in June, whereas it was negative November 2014 through April 2015. Inflation excluding housing had risen slightly less than observed inflation since the beginning of the year. Food and beverage prices have risen by 2.7% since December 2014, in part due to the increase in the lower value-added tax bracket in January. 230 240 0.2 0.1 250 2010 2011 2012 0.0 2013 2014 15 Trade-weighted exchange rate of the króna (inverted left axis) 1 Volatility of the króna (right) 2 1. Price of foreign currency in terms of the króna. Inverted axis shows a stronger króna as a rise. 2. Volatility is measured by the standard deviation of daily changes in the past 3 months. Source: Central Bank of Iceland. 1. The key rate is the interest rate that is the most important determinant of short-term market rates and therefore is the best measure of the monetary stance. At present, this is the seven-day term deposit rate. Other Central Bank interest rates have risen correspondingly, as can be seen in Table 1. 2. It should be borne in mind that, owing to the strike among lawyers at Commissioner s offices in the greater Reykjavík area, no house purchase agreements were registered during the period from 7 April through 14 June 2015. Therefore, calculations of the market price of capital area housing in May and June are not based on new measurements. Monetary Policy Committee report to Parliament 4

Although inflation is still low, the inflation outlook has de terior ated in comparison with the Bank s May forecast, as the wage increases negotiated since then are much larger than is consistent with medium-term price stability. Furthermore, the measures announced by the Government in connection with wage settlements will increase Treasury expenditures and reduce tax revenues and, other things being equal, entail a relaxation of the fiscal stance. There are indications of robust growth in demand, and inflation expectations have risen markedly in the past few months. These factors made it unavoidable to respond to the worsening inflation outlook by raising interest rates in June. Furthermore, it seems apparent that more rate increases will be needed in the coming term, in order to ensure price stability over the medium term. Accompanying documents The following documents are enclosed with this report: 1. Monetary Policy Committee statements from February to June 2015. 2. Minutes of Monetary Policy Committee meetings from February to June 2015. 3. Joint declaration by the Government and the Central Bank on inflation targeting, March 2001. Chart 5 Various inflation measurements 1 January 2001 - June 2015 12-month change (%) 22 20 18 16 14 12 10 8 6 4 2 0-2 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 CPI CPI excluding housing Core index 3 excluding tax effects Core index 4 excluding tax effects Inflation target 1. Core index 3 is the CPI excluding prices of agricultural products, petrol, and public services and the cost of real mortgage interest. Core index 4 excludes the market price of housing as well. Sources: Statistics Iceland, Central Bank of Iceland. On behalf of the Central Bank of Iceland Monetary Policy Committee, Már Guðmundsson Governor of the Central Bank of Iceland and Chair of the Monetary Policy Committee Monetary Policy Committee report to Parliament 5

Accompanying documents Page Statement of the Monetary Policy Committee 4 February 2015 7 Statement of the Monetary Policy Committee 18 March 2015 8 Statement of the Monetary Policy Committee 13 May 2015 9 Statement of the Monetary Policy Committee 10 June 2015 10 Minutes of the Monetary Policy Committe meeting February 2015 11 Minutes of the Monetary Policy Committe meeting March 2015 18 Minutes of the Monetary Policy Committe meeting May 2015 24 Minutes of the Monetary Policy Committe meeting June 2015 33 Declaration on inflation target and a change in the exchange rate policy 40 Monetary Policy Committee report to Parliament 6

No. 3/2015 4 February 2015 Statement of the Monetary Policy Committee 4 February 2015 The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank s interest rates unchanged. The Bank s key interest rate the rate on seven-day term deposits will therefore remain 4.5%. According to preliminary figures from Statistics Iceland, GDP growth was somewhat weaker in the first three quarters of 2014 than was forecast in the Bank s November Monetary Bulletin. There are indications that these preliminary figures may be underestimated; nevertheless, the Bank s updated forecast assumes that GDP growth in 2014 was weaker than in the November forecast, or 2% instead of 2.9%. On the other hand, GDP growth in 2015 is expected to be stronger than previously projected, or 4.2% instead of 3.5%. Inflation has subsided still further since the last interest rate decision. It measured only 0.8% in December and January and was slightly negative if the effects of housing costs are excluded. The outlook is for inflation to remain below 2% into 2016, which is below the November forecast. Low global inflation and a stable króna contain inflation and offset the effects of considerable domestic wage increases. Inflation expectations have fallen as well in recent months and are now close to target by most measures. In many respects, the economic outlook is more uncertain than often before. The drop in petrol prices has had a strong impact on price developments in Iceland and abroad, but it is uncertain how long these conditions will persist. Wage growth has been strong in Iceland, unlike in most trading partner countries, and mounting unrest in the domestic labour market could jeopardise the stability that has been achieved. The Bank s real rate has risen in the recent past, owing to declining inflation and inflation expectations. It is relatively high in view of the current business cycle position and the near-term outlook. Reductions in global fuel prices are beyond the scope of domestic monetary policy, however, and the disinflation resulting from them is temporary. Therefore, in determining interest rates, it is not possible to take full account of the disinflation stemming from this source. The outlook for the labour market is also highly uncertain, and at the same time, there are signs of strong GDP growth in the near future. For this reason, the MPC considers it appropriate to wait until the economic situation becomes clearer, particularly as regards wage developments. As always, developments in nominal interest rates depend on developments in demand and inflation. If inflation remains below target and pay increases in upcoming wage settlements are consistent with the inflation target, conditions for further reductions in nominal interest rates could develop. Large pay increases and strong growth in demand could undermine the recently achieved price stability, however, and require that interest rates be raised again. Monetary Policy Committee report to Parliament 7

No. 8/2015 18 March 2015 Statement of the Monetary Policy Committee 18 March 2015 The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank s interest rates unchanged. The Bank s key interest rate the rate on seven-day term deposits will therefore remain 4.5%. According to recently published national accounts, GDP growth measured 1.9% in 2014, in line with what the Bank had projected in February. The new data confirm the MPC s assessment, published in its last statement, that the preliminary GDP growth numbers for the first nine months of the year had been underestimated and do not therefore materially change the Committee s assessment of recent GDP growth and the economic outlook. Inflation has measured 0.8% in recent months and has been slightly negative if housing costs are excluded. Low global inflation and a stable króna contain inflation and offset the effects of considerable domestic wage increases. Inflation expectations had subsided to target at the beginning of the year. However, there are indications that they have risen again in recent weeks, possibly reflecting expectations that the results of the forthcoming wage settlements will not be in line with the inflation target. The recent episode of low inflation is attributable in part to falling global fuel prices. Reductions in global fuel prices are beyond the scope of domestic monetary policy, however, and the disinflation resulting from them is temporary. The outlook for the labour market is also highly uncertain, and at the same time, there are signs of robust GDP growth in the near future. For this reason, the Committee considers it appropriate, as before, to wait until the economic situation becomes clearer, particularly as regards wage developments. As always, developments in nominal interest rates depend on developments in demand and inflation. If inflation remains below target and pay increases in upcoming wage settlements are consistent with the inflation target, conditions for further reductions in nominal interest rates could develop. Large pay increases and strong growth in demand could undermine the recently achieved price stability, however, and require that interest rates be raised again. Monetary Policy Committee report to Parliament 8

No. 9/2015 13 May 2015 Statement of the Monetary Policy Committee 13 May 2015 The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to keep the Bank s interest rates unchanged. The Bank s key interest rate the rate on seven-day term deposits will therefore remain 4.5%. According to the Bank s newly published forecast, GDP growth will measure about 4½% this year and will average just under 4% per year over the forecast horizon, which is more than was forecast in February. A positive output gap will develop this year and peak in 2016. The recovery of the labour market has gained momentum in the recent term. Given substantial wage demands currently being put forward, it could be concluded that excess demand has already developed in the labour market, or at least that the labour market slack has narrowed more rapidly than is consistent with price stability. Inflation is still low and has been slightly negative if housing costs are excluded. Low global inflation and a stable króna have contained inflation and offset the effects of considerable domestic wage increases. The inflation outlook has deteriorated, however, since the Bank s last forecast. The likelihood of a favourable interaction between low imported inflation and modest wage settlements appears negligible at present, as inflation expectations have risen since the last forecast, after having subsided to target at the beginning of the year. According to the Bank s baseline forecast, inflation will already have risen above the target by the beginning of 2016 and is more likely to overshoot the forecast than to fall below it. Developments taking place in wage negotiations since the forecast was prepared have further exacerbated this risk. The Bank s interest rate reduction late in 2014 was based on a sharp drop in inflation and the decline in inflation expectations, which led to a larger rise in real rates than was considered warranted at that time by economic conditions and the near-term outlook. At that time, however, the Committee pointed out that large pay increases and strong growth in demand could undermine the recently achieved price stability and require that interest rates be raised again. Recent developments in wage negotiations, in conjunction with the increase in inflation expectations and indications of strong growth in demand, suggest that these conditions are now materialising; therefore, it is likely that it will be necessary to raise interest rates at the MPC s next meeting, which will take place in June. Monetary Policy Committee report to Parliament 9

No. 14/2015 10 June 2015 Statement of the Monetary Policy Committee 10 June 2015 The Monetary Policy Committee (MPC) of the Central Bank of Iceland has decided to raise the Bank s interest rates by 0.5 percentage points. The Bank s key interest rate the rate on seven-day term deposits will therefore be 5%. According to newly published national accounts, GDP growth measured 2.9% in Q1/2015. Consumption and investment grew by 6.4% and domestic demand by almost 10%. These figures, together with the strong recovery of the labour market, indicate that economic activity is growing broadly in line with the Bank s May forecast. Although inflation is still low, the inflation outlook has deteriorated markedly from the Bank s last forecast, and inflation expectations have continued to rise. The outlook is for higher inflation than the Bank projected in May because wage increases recently negotiated have been significantly larger than was assumed in the May forecast. In order to facilitate the conclusion of wage settlements, the Government has announced measures that will increase public expenditures and reduce tax revenues. This will entail an easing of the fiscal stance, other things being equal, as they have not been financed. Furthermore, the authorities have announced measures aimed to prepare for liberalisation of the capital controls. Some of these measures will generate revenues for the Treasury, and it is important that these revenues be allocated so as not to stimulate the domestic economy still further, i.e. by activating the hitherto sterile component of money holdings. The MPC will monitor developments closely and will take appropriate countervailing measures if necessary. In recent MPC statements, the Committee has repeatedly pointed out that large pay increases and strong growth in demand could undermine the recently achieved price stability and require that interest rates be raised again. The outlook for developments in wage costs, the increase in inflation expectations, and indicators of robust demand growth make it unavoidable to respond to the worsening inflation outlook now, even though inflation is still below target. Furthermore, it seems apparent that a sizeable rate increase will be necessary in August, followed by further rate hikes in the coming term, so as to ensure price stability over the medium term. Monetary Policy Committee report to Parliament 10

The Monetary Policy Committee of the Central Bank of Iceland Minutes of the Monetary Policy Committee meeting, February 2015 Published 18 February 2015 The Act on the Central Bank of Iceland stipulates that it is the role of the Monetary Policy Committee (MPC) to set Central Bank interest rates and apply other monetary policy instruments. Furthermore, the Act states that [m]inutes of meetings of the Monetary Policy Committee shall be made public, and an account given of the Committee s decisions and the premises upon which they are based. In accordance with the Act, the MPC has decided to publish the minutes of its meetings two weeks after each interest rate decision. The votes of individual Committee members will be made public in the Bank s Annual Report. The following are the minutes of the MPC meeting held on 2 and 3 February 2015, during which the Committee discussed economic and financial market developments, the interest rate decision of 4 February, and the communication of that decision. I Economic and monetary developments Before turning to the interest rate decision, members discussed the domestic financial markets, financial stability, the outlook for the global economy and Iceland s international trade, the domestic economy, and inflation, with emphasis on information that has emerged since the 10 December interest rate decision, as published in the updated forecast in Monetary Bulletin 2015/1 on 4 February. Financial markets Since the December meeting, the króna had appreciated by just over 2% against the euro but had depreciated by just under ½% in trade-weighted terms and just under 6½% against the US dollar, which had appreciated somewhat against most other currencies. The Central Bank s net accumulated foreign currency purchases in the domestic foreign exchange market totalled approximately 112 million euros (roughly 17 b.kr.), or 43% of total market turnover during the period. At the end of 2014, the foreign exchange reserves net of the Central Bank and central government s foreign-denominated debt were positive by 53 b.kr., whereas they had been negative in the amount of 28 b.kr. at year-end 2013. The króna remained relatively stable in 2014, both in trade-weighted terms and against the euro. In trade-weighted terms, it appreciated by just under 2% over the year, as opposed to 11% in 2013. Strong foreign currency inflows supported the currency, and the Central Bank leaned against the appreciation in order to mitigate exchange rate volatility. The Bank s net foreign currency purchases in the interbank foreign exchange market amounted to roughly Monetary Policy Committee report to Parliament 11 1

5½% of estimated year-2014 GDP, the largest amount of currency the Bank has purchased in a single year. Financial institutions liquidity has remained abundant vis-à-vis the Central Bank, and overnight rates in the interbank market for krónur have been below the centre of the interest rate corridor. Interest rates have developed broadly in line with the Bank s nominal rates. Turnover in the interbank market increased sharply towards the end of 2014 but had been limited so far in 2015. Yields on nominal and indexed Treasury and Housing Financing Fund (HFF) bonds declined marginally following the December interest rate reduction. Yields on nominal bonds had risen slightly in the interim, however, and were 0.1-0.3 percentage points higher at the February meeting than at the December meeting. They were about 0.1-0.7 percentage points lower than at the November meeting, however. The lowest listed nominal mortgage rates offered by the three large commercial banks have fallen by an average of 0.5 percentage points since the December meeting and by up to 0.75 percentage points since the November meeting. The average of comparable commercial banks indexed mortgage rates had risen since December, however, whereas they had been inching downwards in the preceding three years, even though other real market rates had risen in line with the increase in the Central Bank s real rate. The monetary stance had tightened since the Central Bank lowered its interest rates in December as inflation and inflation expectations had subsided. The Bank s real rate was 2.4% in terms of the average of various measures of inflation and inflation expectations at the time of the meeting, but 3.7% in terms of twelve-month inflation, which is an increase of 0.2 percentage points since right after the interest rate decision was announced in December. The risk premium on the Treasury s foreign obligations, in terms of the spread between foreign-denominated Treasury bonds and comparable bonds issued by other countries, had risen by 0.2 percentage points against US Treasury bonds but fallen by 0.1 percentage points against German bonds. Just before the February meeting, it measured 1.6-2.2 percentage points. The CDS spread on five-year Treasury obligations had risen by 0.2 percentage points between meetings, to roughly 1.7%. Financial institutions research departments had all projected that the Bank s nominal policy rate would be lowered by 0.25 percentage points in February, on the grounds that the Bank s real rate was higher than the inflation outlook warranted. Growth in money holdings has slowed down, with M3 up just over 3% year-on-year in Q4/2014, excluding deposits owned by special purpose entities and the winding-up boards of the failed financial institutions. Growth has been driven mainly by increased household and corporate deposits. The adjusted total stock of DMB loans to domestic borrowers had grown by 2.8% year-onyear in Q4/2014. Net new DMB lending to domestic borrowers totalled just over 170 b.kr. in 2014, almost ½% more than in 2013. The NASDAQ OMXI8 index had risen by just under 6% between meetings. Turnover in the main market totalled around 277 b.kr. in 2014, an increase of about 10% from the prior year. Outlook for the global real economy and international trade Monetary Policy Committee report to Parliament 12 2

The International Monetary Fund s (IMF) January forecast estimates global GDP growth at 3.5% in 2015 and 3.7% in 2016, or some 0.3 percentage points less in each of the two years than according to the Fund s October forecast. The GDP growth outlook is weaker for emerging and developing countries, especially those that export oil and commodities. For industrialised countries, however, the outlook is slightly better this year, particularly for the US, although the 2016 outlook is unchanged. In comparison with the October forecast, 2015 inflation forecasts for industrialised countries have been lowered by about 0.8 percentage points, to 1%, and 2016 forecasts have been lowered by 0.4 percentage points, whereas they have been raised slightly for emerging and developing countries. Consensus Forecasts year- 2015 GDP growth projections for Iceland s main trading partners are unchanged since the December MPC meeting, although the inflation forecasts have been lowered by 0.6 percentage points. Iceland s goods trade surplus totalled 4.6 b.kr. in December 2014 and 4 b.kr. for the year as a whole. Import values rose by 8½% year-on-year in 2014 and export values by 0.7%. Growth in imports is due mainly to increased transport equipment and consumer goods values, while export growth stems mainly from an increase in the value of industrial exports. The real exchange rate index measured 84.2 points in terms of relative prices in December, an increase of just over 1% month-on-month and nearly 4% year-on-year. The real exchange rate of the króna rose by 6.9% year-on-year in 2014. The increase is due primarily to a 5.7% nominal appreciation of the króna, but in addition, inflation in Iceland was about 1 percentage point above the average among its trading partners. Aluminium prices have fallen by nearly 4% since the last MPC meeting, although the average price was up almost 5% year-on-year in January. Foreign currency prices of marine products had risen by 2.4% month-on-month in December, however, and by 12½% year-on-year. Oil prices fell nearly 28% year-on-year in Q4/2014, and it is estimated that terms of trade had improved by 5% over the same period. The domestic real economy and inflation According to the National Budget for 2015, Treasury revenues will be about 10 b.kr. more than was assumed when the initial budget proposal was prepared, and the entire amount will be used to offset increased expenditures. The budget was passed with a 3.6 b.kr. overall surplus and a 67.9 b.kr. primary surplus. The overall balance is ½ b.kr. less favourable than was assumed in the budget proposal, and the primary balance is 2.2 b.kr. less favourable. The fiscal stance has therefore eased slightly since the last MPC meeting. According to the Statistics Iceland labour force survey (LFS), seasonally adjusted unemployment in Q4 was in line with the Bank s November forecast, measuring 4.8%. It was virtually unchanged between quarters but declined by 0.4 percentage points year-on-year. The survey-based unemployment rate was 5.4% in 2014, about 0.4 percentage points less than in 2013. According to figures from the Directorate of Labour, unemployment measured 3.6% in 2014, a decline of 0.8 percentage points year-on-year. According to the LFS, total hours worked increased by 1.5% year-on-year in Q4/2014, in line with the Bank s November forecast. The rise in total hours worked in Q4 is due in large part to an increase in the number of employed (1%) and a slight increase in average hours worked (0.4%). All other measures of labour supply and demand pulled in the same direction. Total hours worked rose by nearly 2% year-on-year in 2014, following an increase of 3.8% in 2013. Monetary Policy Committee report to Parliament 13 3

The number of employed persons rose by 1.6% in 2014, as opposed to 3.4% in 2013. The increase in averaged hours worked was about 0.4% in both years, however. In Q4/2014, net migration was positive for the ninth quarter in a row. In 2014 as a whole, immigrants outnumbered emigrants by just over 1,100, or 0.6% of the labour force. This is slightly less than in 2013, however, when net migration was positive by 0.9% of the labour force. The net increase in the past two years is due to foreign nationals. In Q4/2014, the wage index rose by 1.4% between quarters and by 6.6% year-on-year, and real wages were 5.4% higher than in Q4/2013. In 2014 the wage index rose by 5.8% year-onyear, about the same as in 2013. Real wages rose about 3.7% between years, the largest increase since 2007. Key indicators of private consumption growth in Q4/2014 imply that growth was relatively strong during the quarter. Payment card turnover grew 5.7% year-on-year and just over 3% quarter-on-quarter. Retail sales and new motor vehicle registrations also increased somewhat. In Q4/2014, the Capacent Gallup Consumer Sentiment Index rose slightly year-on-year but fell quarter-on-quarter. The same occurred in January: the index declined from the previous month but rose year-on-year. The big-ticket index of planned major household purchases, which had risen to a six-year high in September 2014, remained unchanged in the December measurement. The Statistics Iceland nationwide house price index rose by 1½% month-on-month in January, after adjusting for seasonality, and by 6.8% year-on-year. The capital area real estate price index, calculated by Registers Iceland, rose nearly 2½% in December 2014 when adjusted for seasonality. It rose by 9.6% year-on-year. The number of registered purchase agreements nationwide rose by nearly 12% year-on-year in 2014. The average time-to-sale for residential housing in the capital area was just over four months in 2014, as opposed to just under five months in 2013. The CPI declined by 0.7% month-on-month in January, after rising by 0.3% in December. Twelve-month inflation measured 0.8% in January, after falling by 0.2 percentage points since the MPC s December meeting. At present, inflation is due largely to rising house prices, as CPI inflation excluding the housing component had been negative by 0.6% over the previous twelve months. Underlying inflation as measured by core index 3 excluding tax effects was 1.3% in January and had declined by 0.2 percentage points since the last meeting. According to statistical measures, underlying inflation ranged between 1.2% and 1.6%. The fall in the CPI in January was driven mainly by winter sales, the massive drop in petrol prices, and the cancellation of general excise taxes. Petrol prices declined 11% month-on-month and had fallen by 17% in the previous twelve months. Food and beverage prices rose by 2.6% month-on-month, however, owing to the increase in the lower value-added tax rate. Public services and house prices also rose somewhat. Inflation averaged 2% for the year, down from 3.9% in 2013 and 5.2% in 2012. According to the Central Bank survey of market expectations, carried out in late January, respondents expect inflation to measure 2.6% in one year, slightly less than in the October 2014 survey. Market participants expect inflation to average about 3% over the next ten years, which is also somewhat lower than in the last survey. The five- and ten-year breakeven inflation rate in the bond market, as measured by the spread between indexed and nonindexed bond interest rates, measured 3.2-3.4%, slightly less than in December. Based on surveys, this is probably consistent with inflation expectations close to target, considering Monetary Policy Committee report to Parliament 14 4

that the breakeven rate also includes a risk premium due to the uncertainty in the inflation outlook. According to the forecast published in Monetary Bulletin on 4 February 2015, the inflation outlook has changed significantly from the Bank s November forecast. Inflation subsided to target early in 2014 and has declined still further in the wake of falling oil prices. It measured 0.8% in January, the lowest in two decades. According to the February forecast, inflation is forecast to remain below 1% until the latter half of 2015 and below 2% into 2016. This is lower than was forecast in November. As always, the inflation outlook is uncertain. The upcoming wage negotiations are a particular source of concern, as large wage increases could erode the inflation outlook and cause a setback in the economic recovery if they cut into labour demand. There is also much uncertainty regarding the global economy, which has been subject to considerable unrest recently. Oil prices have fallen sharply, and even though the decline is generally conducive to GDP growth, the global GDP growth outlook has somewhat deteriorated since the forecast published in the November Monetary Bulletin, and uncertainty has escalated. The global inflation outlook has also changed markedly. The decline in oil prices has made a strong impact on external conditions, and Iceland s terms of trade have improved substantially. As a result, the outlook is for a larger current account surplus than was assumed in November. According to preliminary figures from Statistics Iceland, GDP growth was somewhat weaker in the first three quarters of 2014 than was forecast in November. Indicators suggest that these figures will be revised upwards. In spite of this, GDP growth for the year as a whole is expected to be weaker than previously estimated, or 2% instead of 2.9%. However, the forecast for GDP growth in 2015 has been revised upwards since November, from 3.5% to 4.2%, due to several factors: positive base effects from weaker output growth in 2014, the marked improvement in terms of trade, and prospects of strong growth in tourism and marine product exports. Nonetheless, the outlook for the next two years is broadly unchanged: GDP growth is forecast to ease somewhat as the demand-side effects of the Government s debt relief package taper off and energy-intensive investment subsides. Growth is projected at approximately 2¾% per year in 2016 and 2017. As was forecast in November, the recovery of the labour market firmed up somewhat in Q4, after a relatively weak third quarter. The slack in the economy therefore continues to narrow and will probably disappear very soon, if it has not already done so. II The interest rate decision The Governor gave the Committee an update on developments since the last meeting, including the work done by the Bank and other authorities in relation to capital account liberalisation. The Committee had also met at an extraordinary meeting on 29 January to discuss possible amendments to the Bank s monetary policy instruments. The Committee considered whether developments since the last regular meeting and the outlook based on the Bank s new forecast changed its assessment of the required monetary stance. Developments in inflation since the December meeting had been in line with the MPC s assessment. Inflation had subsided still further, measuring only 0.8% in December and January, and was slightly negative if the effects of housing costs are excluded. Inflation Monetary Policy Committee report to Parliament 15 5

expectations had fallen as well since the December meeting and, by most measures, were close to target. Committee members agreed that the inflation outlook had changed considerably from the Bank s November forecast. This had been broadly anticipated at the December meeting, however, when the Committee was of the view that inflation would probably remain somewhat below target at least through mid-2015. Members discussed the updated forecast in Monetary Bulletin and were of the view that it was in line with the Committee s assessment from the December meeting that 2014 GDP growth had been weaker than forecast in November. The updated forecast estimated it at 2% instead of the previous 2.9%, based on Statistics Iceland s preliminary figures for the first three quarters of 2014. As was the case at the last meeting, members agreed that it was likely that Statistics Iceland s preliminary figures underestimated the actual pace of output growth, as they deviated markedly from other indicators of demand. On the other hand, GDP growth for 2015 is now forecast to be stronger than forecast in November, or 4.2% instead of 3.5%. This is partly due to base effects, as the preliminary figures suggest that 2014 GDP growth was weaker than previously estimated, and also due to expected stronger export growth and positive effects from terms of trade. Committee members agreed that the spare capacity in the economy had probably disappeared or was about to do so, and the slack in the labour market would probably disappear in 2015. The outlook was still for robust growth in domestic demand, as the forecasted GDP level in 2015 was similar to that forecast in November. The Committee discussed in detail the labour market and wage developments among various groups, both in current wage agreements and over the long term. Members agreed that, as yet, the main reason for labour market unrest was not excess labour demand but, to an extent, conflicts about relative wages and income distribution. Furthermore, the easy access to the international labour market enjoyed by a portion of the employed could be another factor. Because of these conflicts, the likelihood of wage settlements in line with the inflation target had diminished. Even though the Bank s real rate had risen by 0.2 percentage points since the nominal rate reduction in December, owing to the decline in inflation and inflation expectations, it was considered most appropriate to keep interest rates unchanged because, in deciding the monetary stance at the December meeting, the MPC had factored in that inflation would most likely fall between meetings. Members nonetheless agreed that the Bank s real rate was relatively high in view of the current business cycle position. The economic outlook was more uncertain than often before, however. In assessing the near-term inflation outlook, it was necessary to consider the offsetting effects of the growing uncertainty about upcoming wage agreements and the effects of the decline in global oil prices on inflation and inflation expectations. The MPC was of the view that the inflation forecast in the February Monetary Bulletin was more likely to be too low rather than too high. Members considered that the wage settlements since the December meeting and the indications that recent settlements would influence wage demands had reduced the likelihood that moderate three-year contracts would be landed. Members noted that, following the broad-based disinflation over most of 2014, the recent decline in inflation was, for the most part, a direct effect of falling global oil prices. Reductions in fuel prices were beyond the scope of domestic monetary policy, however, and the disinflation resulting from them would be temporary. Therefore, members agreed that, in determining interest rates, it was not possible to take full account of the disinflation Monetary Policy Committee report to Parliament 16 6

stemming from this source. It would therefore not be appropriate to simply consider the increase in the real rate that could be traced to low observed inflation caused by reduced oil prices. If developments in oil prices should begin to affect long-term inflation expectations, however, and spread to wage formation, thereby leading to a prolonged period of belowtarget inflation, a monetary policy response would be called for. The MPC considered it unlikely that this would happen, however. The spare capacity in the economy had more or less disappeared, and robust GDP growth was expected in the near future. Wage growth had been strong in Iceland, unlike in most trading partner countries, and mounting unrest in the domestic labour market could jeopardise the stability that had been achieved. For this reason, the Committee agreed that it was appropriate to wait until the economic situation became clearer, particularly as regards wage developments. In view of the discussion, the Governor recommended that the Bank s interest rates be held unchanged. The Bank s key rate (the seven-day term deposit rate) would remain 4.5%, the current account rate 4.25%, the seven-day collateralised lending rate 5.25%, and the overnight lending rate 6.25%. The proposal was approved unanimously. Committee members agreed that, as always, developments in nominal interest rates would depend on developments in demand and inflation. The Committee was of the opinion that, if inflation remains below target and pay increases in upcoming wage settlements are consistent with the inflation target, conditions for further reductions in nominal interest rates could develop, other things being equal. On the other hand, they were of the opinion that large pay increases and strong growth in demand could undermine the recently achieved price stability and require that interest rates be raised again. The following Committee members were in attendance: Már Gudmundsson, Governor and Chairman of the Monetary Policy Committee Arnór Sighvatsson, Deputy Governor Thórarinn G. Pétursson, Chief Economist Gylfi Zoëga, Professor, external member Katrín Ólafsdóttir, Assistant Professor, external member In addition, a number of Bank staff members attended part of the meeting. Rannveig Sigurdardóttir wrote the minutes. The next Statement of the Monetary Policy Committee will be published on Wednesday 18 March 2015. Monetary Policy Committee report to Parliament 17 7

The Monetary Policy Committee of the Central Bank of Iceland Minutes of the Monetary Policy Committee meeting, March 2015 Published 1 April 2015 The Act on the Central Bank of Iceland stipulates that it is the role of the Monetary Policy Committee (MPC) to set Central Bank interest rates and apply other monetary policy instruments. Furthermore, the Act states that [m]inutes of meetings of the Monetary Policy Committee shall be made public, and an account given of the Committee s decisions and the premises upon which they are based. In accordance with the Act, the MPC has decided to publish the minutes of its meetings two weeks after each interest rate decision. The votes of individual Committee members will be made public in the Bank s Annual Report. The following are the minutes of the MPC meeting held on 17 March 2015, during which the Committee discussed economic and financial market developments, the interest rate decision of 18 March, and the communication of that decision. I Economic and monetary developments Before turning to the interest rate decision, members discussed the domestic financial markets, financial stability, the outlook for the global economy and Iceland s international trade, the domestic economy, and inflation, with emphasis on information that has emerged since the 4 February interest rate decision. Financial markets The exchange rate of the króna had risen by 2.2% against the euro and by 0.6% in tradeweighted terms since the February meeting but had fallen by 4.4% against the US dollar and 2.5% against the pound sterling. The Central Bank s net accumulated foreign currency purchases in the domestic foreign exchange market totalled approximately 129 million euros (roughly 19 b.kr.), or just under half of total market turnover during the period. Financial institutions liquidity has remained abundant vis-à-vis the Central Bank, and overnight rates in the interbank market for krónur have been below the centre of the interest rate corridor. Turnover in the interbank market has been extremely limited year-todate. Yields on long-term nominal Treasury bonds had risen by 0.1-0.4 percentage points since the February meeting, but yields on indexed Treasury and Housing Financing Fund (HFF) bonds had declined by 0.3-0.5 percentage points. Monetary Policy Committee report to Parliament 18 1

The lowest listed nominal mortgage rates offered by the three large commercial banks had remained unchanged since the February meeting. Comparable rates on indexed loans were also unchanged, apart from one commercial bank s variable rates, which had risen by ½ a percentage point. The monetary stance was broadly unchanged since the Committee s February meeting. At the time of the March meeting, the Bank s real rate was still 2.3% in terms of the average of various measures of inflation and inflation expectations, and 3.7% in terms of twelve-month inflation. The risk premium on the Treasury s foreign obligations, in terms of the spread between foreign-denominated Treasury bonds and comparable bonds issued by the US and Germany, had declined by 0.3-0.4 percentage points and measured about 1.1-1.7 percentage points just before the March meeting. The CDS spread on five-year Treasury obligations had risen by 0.1 percentage points between meetings, to 1.8%. Financial market analysts had all expected the Central Bank s nominal interest rates to remain unchanged in March. They cited the uncertainty about ongoing wage negotiations and the fact that year-2014 GDP growth had been in line with the Bank s forecast as grounds for their projections. Growth in money holdings has slowed down in the recent term, with M3 down by just under 2% year-on-year in January, excluding deposits owned by special purpose entities and the winding-up boards of the failed financial institutions. The contraction is due mainly to a contraction in financial institutions deposits. The adjusted total stock of deposit money banks (DMB) loans to domestic borrowers declined by 2.3% year-on-year in January. DMBs net new lending (new loans net of prepaid older loans) to domestic borrowers totalled just over 4 b.kr. in January. At the same time, households prepayments exceeded new loans taken by 166 m.kr. A large share of households mortgage prepayments during the month can be traced to loan write-downs and accumulated mortgage payments made with third-pillar pension savings associated with the Government s debt relief package. The NASDAQ OMXI8 index had fallen by just over 2% between meetings. Turnover in the main market totalled around 59 b.kr. during the first two months of the year, about the same as in the corresponding period in 2014. Outlook for the global real economy and international trade Iceland s goods trade surplus measured 7.1 b.kr. in January and, according to preliminary figures, 6.6 b.kr. in February. Export values rose 11.7% year-on-year at constant exchange rates in the first two months of the year, due to an increase in marine and industrial product exports. Import values rose by 9% over the same period, owing mainly to increased imports of commodities, operational inputs, and food and beverages. Terms of trade for goods and services improved by 3.4% year-on-year in 2014, a percentage point more than was forecast in Monetary Bulletin 2015/1. The greater improvement is due to favourable developments in export prices of aluminium and marine products during the fourth quarter of the year. Aluminium prices had fallen by 7% since the last MPC meeting, although the average price was up 4% year-on-year during the first two weeks of March. Foreign currency prices of marine products rose slightly between months in January and had risen 14% year-on-year at Monetary Policy Committee report to Parliament 19 2