Strange Statements by Icelandic Central Bankers

Those who realize that the causes of inflation can be diverse have been surprised by the Central Bank’s analyses and statements on various inflation levels from 2021.

The Central Bank generally assumes that inflation is mainly caused by excessive demand pressure (excessive consumption and investments) and uses interest rate increases to reduce the public’s purchasing power, hoping that demand will decrease. This affects mainly the lower-income and middle-class groups of society. High-income people generally feel little burden of interest rates and therefore generally don’t reduce their consumption as much as other groups.

However, high interest rates have reduced investments and greatly slowed economic growth. The economy is now facing stagnation (a 4% decline in GDP occurred in the first quarter of the current year), but inflation is still persistent. Doesn’t that indicate that the wrong medicine is being used for the disease?

The bank overlooks the fact that the most important explanation for the current inflation is an imbalance in the housing market – far too few new apartments have been built, i.e. due to the Central Bank’s high interest rates. The high-interest costs of indebted companies also put pressure on prices. Thus, the high-interest rate is partly the cause of persistent inflation. The Central Bank has reacted to this in the wrong way, and the prospect is that it will continue to do so. This can be deduced from the latest statement of the bank’s Financial Stability Committee this week and subsequent interviews with the Central Bank Governor in the media.

The following are some particularly alarming statements from the Central Bank:

  1. The Financial Stability Committee now says: “There are signs that the economy has started to slow down at the same time as real interest rates rise.” This is an understatement of the biggest kind. Economic growth was 8.9% in 2022, 4.1% last year and now it is down to -4% in the first quarter! Such an amazing transition in the economy does not move the Central Bankers more than they call it “a sign that the economy is slowing down…”. The bank governor says he wants to see a further cooling of the economy this summer, but this has already become a cooling as in wintertime Siberia!
  2. The Financial Stability Committee now says: “The increase in real interest rates has narrowed the disposable income of households and the operating environment of companies. It looks like this effect could be even greater in the coming seasons.” The first sentence is certainly correct, but the second one suggests that the bank does not intend to change anything in the coming months. The same wrong measures will continue to be used and households and businesses will continue to bear the burden.
  3. In an interview on June 5, the Central Bank Governor said that most industries are currently in recession, except for the construction industry. Then he added that it could be “dangerous for the construction industry to surpass other industries in this way”! But that is exactly what is most needed, for the construction industry to build more apartments to reduce the shortage in the housing market, which keeps inflation up with excessive increases in apartment prices. These comments indicate some lack of realism in the bank.
  4. In an interview on the same day, the Central Bank Governor also said that wage increases in the newly concluded collective agreements are increasing inflation from 6% to 6.2%. The labor movement negotiated a 4% increase in wage costs for the current year, to just over 6% inflation. In other words, a decline in purchasing power was agreed upon, but the bank manager still allows himself to claim that collective agreements are increasing inflation now.

The criteria of the collective agreements were in line with the bank’s previous message about wage increases that are in line with 2.5% inflation. Therefore there is no reason why such modest wage increases are driving inflation now. This statement by the Central Bank Governor comes as a wet rag in the face of the labor movement. Serious conclusions must be drawn from this.

I have previously argued that it is urgent to deal with inflation differently and that the government needs to take measures that focus on the real roots of inflation. The Central Bank’s measures are not working well enough and are causing significant damage to the economy and the operations of households in the lower and middle-income groups.

The latest message from the Central Bank thus raises little hope for reforms in the treatment of inflation, and thus there is little hope for better times in the coming months.

The government needs to take action with direct, decisive interventions, especially in the housing market, but also with consumption-inhibiting measures that affect those with higher incomes and wealthier people. Those groups are most likely to sustain excessive demand pressure, but not the indebted low-wage earners who feel the most from the Central Bank’s interest rate hikes.

Stefán Ólafsson is professor emeritus at the University of Iceland and works as an expert at Efling.

The article was first published in Heimildin on June 8, 2024.