Is the Central Bank of Iceland extreme?

Stefán Ólafsson writes

The Central Bank of Iceland is still raising the banks interest rate, although real interest rates are already above the long-term average (1.5%). With the policy rate at 9.25% and inflation at 7.6%, the bank is in a very unique position when looking at the countries we compare ourselves to. This can be seen in the attached picture.

The euro countries have an interest rate of 4.25% and the other Nordic countries are between 3.35% and 4.25%. The US has 5.5% and the UK 5.25%.

There are only countries in Eastern Europe that currently have higher interest rates than Iceland, either countries at a much lower level of prosperity than Iceland or war-torn countries such as Ukraine and Russia – and then Turkey, which is experiencing hyperinflation.

Is this because inflation is so much higher in Iceland than in the main neighboring countries? No, absolutely not. For example, it is over 9% in Sweden, although the interest rate there is only around 3.75%. It is still most common for policy rates to be lower than the inflation rate in Europe.

This comparison shows that the Central Bank of Iceland is on a very special path – which seems to be based on extreme goals to reduce the benefits of those with housing debt. It affects those with lower incomes, younger people in the housing market, single parents and immigrants the most. In addition, this reduces the much-needed new construction of apartments for those with lower incomes. This is both unfair and irrational.

The central bank says that the reason for the recent increases in key interest rates is too much demand expansion in the economy – too much consumption. Yet private consumption has already stopped increasing and the housing market is now closed to less wealthy families.

Almost half of the population is now struggling to make ends meet. Is it the people who are sustaining demand expansion in the economy?

No, something else! It is the more affluent half of the population and the overgrowth of the tourism industry that are sustaining demand expansion. The increase in the policy rate has little effect on those people and those companies, due to their ample purchasing power and good financial position.

The reasoning behind the extreme policy of the Central Bank of Iceland seems to be this: “Now the more affluent half of the population is spending too much (both at home and abroad) and then the conditions of the less affluent half must be reduced by a significant amount.”

And as far as tourism is concerned, the theory seems to be this: “Now tourism is growing too fast, with too much import of new labor – and then it should be left alone, even maintaining stimulating tax credits”.

Why is it not possible to apply other measures that actually reduce the excess demand of those who play loose tail?

Is it written somewhere in the central bank’s rule book that it should primarily serve the wealthier half of the population?

The author is a professor emeritus at the University of Helsinki and works as an expert at the Efling union.