Iceland’s PM is out. The krona has slid 30% v. the euro this year.
Iceland’s central bank has increased rates significantly. But it may not be enough.
There are now calls for Iceland to adopt a pro-cyclical fiscal policy, and pare back on spending even as the economy cools.
I thought that was the sort of thing that only happened in emerging economies.
Iceland imports a fair amount, so the falling krona seems to be having an impact on import prices and thus inflation. I haven't looked carefully at the data, but that was the impression I got from the reading the FT. Thus the calls for fiscal restraint to help reduce demand for imports and help curb inflation …
A plunging currency. A (formely?) over-heated housing sector. Falling capital flows despite rising interest rates. Pressure for fiscal adjustment to help spur current account adjustment – even if it means less growth.
An omen for the US?
Iceland was the darling of the hedge fund carry trade world before it wasn’t. Best I can tell, the US relies more on central banks (along with Japanese day traders) and less on hedge funds to finance its deficit. And so far they have been a bit more forgiving. Very forgiving actually. Whenever the private markets lose appetite for financing the US, they have stepped up.
Still, there are some hints that the world is changing. Last year, everyone wanted to fund current account deficits for a bit of carry. This year, not so much. Last year, private investors were willing to finance a sizeable fraction (but certainly not all) of the US current account deficit. This year, the US may only be able to sustain a large and growing current account deficit only if its official financers are willing to increase the credit that they provide the US.
Iceland is not the only country with large and growing current account deficits whose currency has fallen this year. The Turkish lira -- another former darling of the high carry world -- has had a bit of touble too. And I suspect the economies of Iceland and Turkey will both cool this year. Turkish growth has been fueled by construction, housing price appreciation and rapid growth in mortgage lending. And long-term lending in lira doesn’t look to be as good a bet now as it did last year, not with inflation rising. Policy interest rates in Turkey look to be heading up ... that hurts, even as a weaker lira helps Turkey's manufacturing sector.
The US inflation scare may not be as serious as the Turkish inflation scare, but inflation also may not be quite so well contained that the Fed can pause. The US central bank -- like the Turkish central bank -- may have to choose between price stability and growth in a way that it hasn't had to up until now.
And even if the dollar's 2006 slump pales relative to that of the krona, I do think the krona's troubles should be something of a wake-up call. Currency crises don't just happen in emerging economies. And sometimes deferring needed adjustments does have a cost.