Iceland: A deep recession
After a long period of unbalanced growth, the Icelandic economy has entered a deep recession following the failure of its major banks. The economy is projected to shrink until early 2010 and unemployment to soar over the next two years. Following a large depreciation of the currency, inflation is projected to spike higher, though to fall back sharply once the exchange rate effects have passed through and the effects of substantial economic slack come to bear. The current account deficit should decline markedly.
The authorities are facing very difficult challenges. Apart from remedying the banking crisis, they will need to ensure that inflation does indeed fall quickly. The central bank’s task would be facilitated if wage setters were to look through much of the spike in inflation resulting from the depreciation of the exchange rate. Bank regulation will need to be reformed, including through stricter rules on bank governance, to ensure that a similar crisis does not recur.