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Strong Central Bank response to COVID-19

The Central Bank of Iceland (CBI) slashed its key interest rate by 0.50 percentage points and lowered the banks’ minimum reserve requirements on Wednesday, in a positive and important step towards mitigating the economic blows from the COVID-19 epidemic. It is of vital importance that other economic policy makers pull in the same direction as soon as possible so as to clarify the overall response before the economic impact strikes with full force.

On Wednesday morning, the CBI lowered its policy interest rate by 0.50 percentage points, bringing the key rate — the rate on seven-day term deposits — to 2.25%. The Bank’s interest rates are now at their lowest since the adoption of the inflation target in March 2001. In addition, the Monetary Policy Committee (MPC) announced that it had decided to lower deposit institutions’ average reserve maintenance requirement from 1% to 0% and to treat their fixed reserve requirements as liquidity buffers. The total estimated impact of this measure is equivalent to a 40 boost in the commercial banks’ liquidity.

With these decisions, the MPC has eased the monetary stance in response to a darkening economic outlook. In the statement it released today, the MPC also says that it will continue to monitor economic developments in the near term and will use the tools at its disposal to support the domestic economy.

A rate cut was generally expected Wednesday morning, after the news broke on Tuesday that the interest rate decision had been pushed forwards by a week. Other actions from the Central Bank were expected as well, and have indeed materialised as described above. The CBI’s measures are in line with the responses of most other central banks around the world. With the aforementioned reduction in minimum reserve requirements and expected flows of liquid assets from the Housing Financing Fund (HFF) to financial institutions, the commercial banks’ liquidity can be expected to increase by as much as 70 in the next few weeks. This is an important move towards ensuring ready access to liquid assets throughout the financial system in the near term.

Economic outlook considerably bleaker, but fundamentals are strong

At the press conference on Wednesday’s interest rate decision, Governor Ásgeir Jónsson said the MPC was ready to call extraordinary meetings as needed in the near future. It was clear that the CBI’s macroeconomic forecast from February was obsolete and that the near-term economic outlook was considerably bleaker than had been assumed then. Deputy Governor Rannveig Sigurðardóttir mentioned that economic scenarios were being prepared for use both within the CBI and by the Government. On the other hand, the CBI’s next formal forecast would be issued as planned in May, as substantial uncertainty remained and assumptions were constantly changing.

The Governor pointed out that Iceland was facing the current economic shock from a position of greater strength than ever before. The banks were much better capitalised, the public sector much less leveraged, and the CBI’s International reserves sizeable. Furthermore, Iceland had a hefty current account surplus and a positive international investment position. Stability was greater than before, also. All of this, he said, made it possible to ease the monetary stance without being concerned about inflation.

In response to questions, the Governor said the MPC remains confident that the impact of the interest rate tool can affect the real economy. He noted that a large share of Icelandic firms’ debt bears variable interest rates and that liquidity facilities for firms in need of them would also bear variable rates. In this regard, monetary policy was much more powerful now than it had been previously. That said, it would take longer for lower interest rates to be transmitted through other channels; for example, it was unlikely that investment would surge in the immediate future, even if financing were cheaper.

All together now!

The CBI’s actions come in the wake of an action package introduced by the Government on Tuesday. It must be said, however, that both the measures and the presentation from the CBI were much better thought out than those announced by the Government the day before. Presumably, many observers were calmed by the tone the CBI took in saying that it would monitor developments and was ready to respond quickly to changes in the outlook by using the tools at its disposal. Hopefully, the Government’s investment strategy, expected before the end of March, will shed clearer light on the mitigating measures planned for coming quarters. It is also of vital importance that levies on the tourism sector — and the domestic economy more generally — be eased temporarily while the worst of the shock is underway and the outlook is still emerging. A reduction in the payroll tax seems to be a useful way to do this.

The puzzle pieces that are still missing in the overall economic response to the COVID-19 epidemic centre not least on municipal authorities and the application of macroprudential tools. It is important that local authorities step forward as State authorities have done, including updating their investment strategies and temporarily easing public levies. Another measure that surely must merit consideration is reducing the capital requirements and tax burden imposed on financial institutions. Lowering the countercyclical capital buffer would be a handy measure, as would a reduction in the bank tax. Both of these would better enable the banking system to provide credit to Icelandic companies on favourable terms. In our opinion, it is important that a comprehensive view of economic policy responses be made clear before the full impact of the COVID-19 epidemic hits households and businesses. This would greatly reduce uncertainty, as well as reducing the risk of a negative spiral of low expectations, falling demand, and a weaker private sector financial position.

Positive response in the market

The markets appear to have welcomed Wednesday's news. As of noon on Wednesday (12:30 hrs.), yields on nominal Treasury bonds had fallen by 11-21 basis points since the markets opened, and indexed yields fell by 4-10 bp. According to the Treasury yield curve, the nominal long-term base interest rate is now around 2.5% and the indexed long-term base rate is 0.2%. To the best of our knowledge, the former of these has never before been this low. Share prices rose more or less across the board, too, lifting the OMXI10 4.7% above yesterday’s market close.


Jón Bjarki Bentsson


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