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Adventures In Icelandic Monetary Policy

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by Felix Salmon
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Oct 28 2008 11:09am EDT

Adventures in Icelandic Monetary Policy

What does it mean that Iceland has just raised interest rates by 600bp, after cutting them by 350bp a couple of weeks ago? I'm not talking about monetary policy here, I'm talking about what it means in practice. Central bank interest rates, after all, are the rate at which national banks can borrow overnight funds. So does this mean that Iceland's big three banks are actually borrowing new money, even though they're all insolvent?

The decision to raise rates is being painted as an attempt "to return to a market-based floating exchange rate regime". But the reason that regime fell apart was nothing to do with Iceland's monetary policy. Rather, it was a function of the fact that anybody looking to earn interest on Icelandic krona deposits would have to have that money on deposit with an Icelandic bank. Which, in turn, meant taking bank credit risk on top of FX risk. And if you wanted to take bank credit risk, you could make much more money by selling default protection.

So I suspect that this latest move by the central bank is largely symbolic. No liquid currency market can exist in a country without a functioning banking system. Unless and until Iceland gets solvent banks -- either new ones or restructured old ones -- the krona will continue to trade largely through newspaper classified ads.

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