Financial indexation and interest rate policy in Iceland

Abstract

Iceland´s experience of rapid post-war inflation developments prompted a unique experiment with a near-comprehensive financial indexation that may be worthy of consideration for a number of individual countries as well as for international capital markets. The indexation policy came to its full fruition with such an articulated system as from 1979, while credit terms were still administered in detail by the Central Bank. The following period thus became ripe with experiences of running such a system and reaping its benefits. The problem of measurement of inflation was solved by a composite, weighted index of consumer and construction prices, and later to include wages, while finally the preference was for consumer prices alone. This simplification minimized the problem of time lag from measurement to application that had proved considerable under accelerating inflation into higher doule digits. Prior to indexation the stock of financial savings had seriously deteriorated in real and relative terms, mainly due to accumulated effects of negative real interest. With indexation, followed within a few years by free interest formation, the tide was turned over to rapid accumulation of financial capital that soon brought about internal demand equilibrium and restored the role of interest and demand policies in general, as well as greatly improving the external debt position. Bond issues rose to prominence pari passu with indexation with resulting multiplication of market instruments which developed further through share issues and stock exchange operations. The overall achievement has been one of a highly modernized financial system. While thus aiming at protecting the financial system against the ravages of inflation, no illusions were held as to indexation leading to an easy solution of inflation itself. However, it has obviously eliminated the inflation gains of the public at large, and thus stamped out the inflation mentality and substantially eased the task of disinflation.