Inflation forecasts and inflation targets of the Central Bank of Iceland

Abstract

Price stability is the main objective of monetary policy according to the Central Bank Act from 2001. The Research Department of the Central Bank maintains a quarterly model of the Icelandic economy and publishes a concise description of it. Inflation is modelled as an expectations-augmented Phillips curve. The policy rate is the main instrument of the Bank for achieving price stability. It follows a Taylor rule in the model and also in practice most of the time. At this time the bank adopted the policy that its inflation predictions and associated interest rate path should reach the inflation target within three years. The effects of policy rates were inadequate for this, but the target was reached by assuming that expectations would adjust quickly to the target although no sign of such tendency was detectable in their past. The interest rate difference is not included in the model from 2009, but inflation expectations are represented by lagged inflation, expected future inflation in two years and the inflation target. This model also predicts a rapid convergence towards the target, but the fit with observed inflation is inacceptable.