Iceland: 2014 Article IV Consultation and Fifth Post-Program Monitoring Discussions-Staff Report; Press Release; and Statement by the Executive Director for Iceland

KEY ISSUESIceland has reached a relatively strong macroeconomic position with good growthprospects. But crisis legacies are still being unwound, including high debt and a largebalance of payments (BOP) overhang contained by capital controls. Amidst publicpressure for a return to normalcy, policies remain geared towards addressingvulnerabilities, rebuilding buffers, and further strengthening key institutions.The monetary policy stance has struck an appropriate balance, but is at a difficultjuncture. The Central Bank of Iceland (CBI) will need to carefully balance deflationarypressures evident in goods prices against a closing output gap and potentially largewage increases in the upcoming bargaining round. The CBI should continue FXaccumulation as conditions permit to smooth eventual BOP outflows. The CBI legislativeframework review needs to support independence, accountability, and policy credibility.With Iceland on-track to achieve core public finance objectives, fiscal policy is wellpositioned for a transition from consolidation to supporting higher potentialgrowth. The budget is in surplus and public debt is on a downward sustainable path.The government is appropriately aiming to institutionalize its objectives with aproposed budget framework law. With crisis-legacy issues gradually subsiding, themedium-term fiscal policy mix should aim for higher growth, while consideringdistributional and external sector impacts.Banking sector buffers have been rebuilt but gaps remain in bank supervision andfinancial safety nets. Faster progress is needed to strengthen deposit insurance, bankresolution, and emergency liquidity assistance frameworks. A permanent solution isneeded for the loss-making government-owned Housing Financing Fund (HFF).Progress in these areas will provide supportive conditions for successful capitalaccount liberalization and external financial reintegration. The authorities expectsignificant progress in the coming months in finalizing and implementing an updatedliberalization strategy. The updated strategy should aim to preserve stability and bebacked by supportive macroeconomic and financial sector policies.