Even as all eyes have been on the United States as its giant economy seemingly swirls around the event horizon of a recession, tiny Iceland finds itself in the grips of an inflationary vise that is savaging its currency, straining its financial system, and threatening to strangle its economy. How that nation fares in its battle with inflation could have ramifications beyond that island nation's borders given how connected its banking system is with the world's economies.

Presently, Iceland's Central Bank is pursuing its fight with inflation with vigor. In a preemptive move ahead of its regularly scheduled meeting on April 10, Iceland's Central Bank raised that country’s benchmark interest rate by 125 basis points to 15%. On April 10, another interest rate hike is possible, though not yet assured.

At the central bank’s annual meeting, its colorful chairman, Davíð Oddsson, issued a call to arms against swelling inflation, warning that much tougher measures might be required. With March consumer prices having risen 1.5% from February and 8.7% from a year earlier, he observed that from the Central Bank’s vantage point, “the telescope points, in all weathers, at inflation.” He explained that inflation is “extremely harmful” when it becomes “immoderately high” as is currently the case in Iceland. Moreover, he warned that inflation “will cause important damage if it continues to grow and the Central Bank cannot contain it through conventional measures within a reasonable period of time.” The window on that “reasonable period of time” might well be closing. In its November 2007 “Monetary Bulletin,” the central bank revealed, “Inflation has continually exceeded the Central Bank’s target ever since May 2004 and was more than 1½ percentage points above target for the entire period from September 2005 to July 2007.”

Aware of the growing magnitude of Iceland’s struggle with inflation, Oddsson minced no words in arguing that “a contraction in demand” is necessary to restoring “any real equilibrium” in Iceland’s economy. While acknowledging that “the battle against the disease called inflation could be lengthy and uncomfortable,” he asserted that the Central Bank has no other choice. He explained:

As time passes, the treatment of the disease could generate unpleasant side effects, and it might be tempting to do away with those side effects in the vain hope that the illness will somehow cure itself. Indeed, we have heard this irresponsible notion expressed in various quarters recently. Anyone who has come down with a persistent illness is familiar with the physician’s demand that the patient complete the course of treatment prescribed to him. If he does not, he runs the risk that the bacteria attacking him will become resistant to the medicine best suited to fight them, with the result that the medicine will work poorly or not at all the next time it is needed. The tactic of last resort under such circumstances is to prescribe a much stronger dose, which inevitably produces much more dire side effects. If a central bank, either the one located in this building or another one, should change its course in mid-stream because of escalating pressure stemming from painful side effects, it is hardly likely that such a bank would be taken seriously when it next attempted to mount a campaign against inflation.

Even if the Central Bank raises interest rates—possibly by 100 or more basis points on April 10—the fight against inflation is likely to remain difficult. A growing risk of a disorderly decline in the króna highlights the magnitude of the challenge confronting the Central Bank.

Last week’s interest rate hike was carried out, in part, to try to stem an accelerating slide in Iceland’s currency. The króna had fallen 30% against the Euro this year and there was a genuine likelihood that the decline could have become increasingly disorderly. If that happened, Iceland could have been subjected to a severe economic shock. In its March 25, Monetary Policy Statement, the Central Bank declared:

The real exchange rate of the króna is now very near a long term historical low which it reached in November 2001. If that development is not reversed and a period of persistent inflation would be ahead with spiraling increases in prices, wages and the price of foreign exchange. The depreciation of the króna in recent weeks also undermines the Balance Sheet of indebted households and businesses and thus financial stability looking further ahead. It is therefore crucial that the depreciation of the króna is reversed as quickly as possible.

Although higher interest rates should stem the króna’s slide, more remains to be done if the currency is to be stabilized and then strengthened. Perhaps the largest reason for the currency’s deterioration is Iceland’s chronic massive current account deficits. In 2006, that deficit amounted to 25.6% of GDP. In 2007, that deficit fell to 15.8% of GDP, but economists forecast only a small decline this year and next. To put things into context, a 15.8% current account deficit would be the equivalent of a $2.19 trillion trade deficit for the U.S. last year.

Such massive trade deficits are not sustainable. Research by the International Monetary Fund (IMF) reveals that major adjustments in which trade deficits unwind typically begin when the current account deficit averages around 4% of GDP. The typical correction is about 6% of GDP, but some corrections have been much larger. For example, Portugal underwent an adjustment equivalent to 18% of GDP beginning in 1981.

Furthermore, while such adjustments can be relatively painless, there are numerous cases in which they have been painful. Such painful reversals experienced “significant growth deterioration.” If early data is representative, the odds might favor the latter scenario for Iceland. First, the króna has already fallen much farther than the average of a real 12% depreciation associated with such adjustments. Second, confidence in the króna is eroding in Iceland, with a growing number of firms seeking a shift to the Euro. Third, inflation has rocketed in recent months even in the face of rapidly rising interest rates. Fourth, the U.S. economy is facing a period of sluggishness brought about by the collapse of a housing bubble and spot shortages of liquidity, and many economies worldwide are either slowing and/or facing inflation. Fifth, Iceland has sizable foreign debt. Sixth, confidence in Iceland’s banking system is weak.

Nevertheless, Iceland’s has at least one notable advantage that might work to its advantage. Unlike in the U.S. where fiscal restraint crumbled with a budget deficit of $500 billion or more possible this year, Iceland has been running regular sizable budget surpluses. Last year, Iceland’s budget surplus amounted to 5.4% of GDP. That would be the equivalent of a $747 billion budget surplus in the U.S. for 2007. That success story might mitigate the risk of a massive capital outflow as Iceland undergoes its economic transition and its Central Bank continues to wage its battle against inflation.

Quatrotritikali,

The opening post in this thread is my commentary on the issue. The main source of the quotes is from various Monetary Bulletins published by Iceland's central bank and speeches made by its chairman, Davíð Oddsson. The historic experience concerning the unwinding of trade deficits is from research conducted by the International Monetary Fund. I specifically noted these sources in the opening thread and even italicized the larger passages I found relevant to my point that Iceland was confronted by a major struggle with inflation.

For what it is worth, the Monetary Bulletin that was released just subsequent to the central bank's decision to raise its benchmark interest rate to 15.5% can be found at: Central Bank of Iceland » Publications*» Monetary Bulletin*» April 2008.

Three months after I posted about Iceland's colossal struggle with inflation, that epic economic battle rages on. Inflation remains on the rampage. The policy rate stands at 15.50%. Early hints of a potentially substantial recession have begun to manifest themselves.

Some highlights from the Sedlabanki's July 3, 2008 monetary policy report:

Today, Iceland's central bank held its benchmark interest rate at 15.50%, as inflation continued to rise. The year-on-year inflation rate in June came to 12.7% vs. the 8.7% figure for March. Inflation is now running at an 18-year high and inflation expectations remain unanchored.

Furthermore, the embattled central bank noted that wage increases will likely prolong the period of excessive inflation. With inflation running some 10 percentage points above the central bank's target, the central bank has warned that it will need to retain the current high rate of interest and perhaps increase it further. Should wages continue to increase, the central bank has suggested that the policy rate could be increased and possibly to as high as 17%.

At the same time, in a press conference on May 23, the central bank's chairman of the Board of Governors Davíð Oddsson suggested that the bank would maintain high interest rates until the excessive inflation receded. At that news conference, he was asked, "How long does the Central Bank believe businesses in Iceland can tolerate these high interest rates?"

He responded:

It is abundantly clear that this high interest rate is not a pleasant thing for anyone in need of market funding, but it is the only tool that we in this Bank have in order to unwind the significant inflationary pressure in the economy, and we must use it. Various other tools can be used as well, but it is in other people’s hands to ensure that they are also used. But to answer directly, we expect that when the economy slows down, interest rates can begin to taper off, and the downward cycle can take place in an orderly manner when that time comes.

Nevertheless, there are now some early signs that a significant recession could be approaching. Total hours worked among Icelanders fell for the first time since the Fourth Quarter in 2004. Iceland's real disposable income has fallen by around 4% since last year, its biggest decline since the early 1990s. Residential investment is now forecast to "contract significantly" and a decline in housing prices could, in the central bank's opinion, help roll back inflation.

Furthermore, Iceland's central bank now anticipates a serious recession. Between now and the end of 2010, real disposable income is projected to decline 11% and real private consumption is expected to fall 15.5%. Home prices are forecast to 19% in nominal terms and around 30% in real terms. That downturn in home prices has already begun. Real GDP is forecast to contract about 2.0% in 2009 and 1.9% 2010. The overall real contraction would amount to approximately 3.9%. To put things into context, no U.S. recession since 1950 has seen such a large decline in real GDP.

As per the central bank's alternative scenarios, the two biggest risks that could further exacerbate and prolong the excessive inflation would be a sharp decline in the króna in the foreign exchange markets and/or large wage hikes. On the other hand, a sharper than expected deterioration in the housing market could dampen inflation.

All said, Iceland's epic struggle with inflation continues. However, three months later, there are the first indications that Iceland's high interest rates may be giving rise to a significant economic contraction that could ease the inflationary pressures.