Globalization and the Icelandic Rollercoaster Ben Hunt The

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 inflation • Increased openness to international goods markets also implies less control over domestic prices and thus demand 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 Efficient Monetary Policy Frontiers Standard deviation of CPI inflation from target 3. 5 3. 0 2. 5 2. 0 1. 5 Iceland 1. 0 New Zealand 0. 5 Canada 0. 0 0. 5 U. K. 1. 0 1. 5 2. 0 2. 5 Standard deviation of output from potential 3. 0 3. 5

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 3. 5 Inflation variability 3. 0 2. 5 2. 0 1. 5 1. 0 0. 5 0. 0 0. 5 1. 0 1. 5 2. 0 Output variability 2. 5 3. 0 3. 5

Rules-Based Fiscal Framework Interest Rate vs. Exchange Rate 11 Interest rate variability 10 9 8 7 6 5 4 6. 0 6. 5 7. 0 7. 5 Exchange rate variability 8. 0 8. 5

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