In some sense, this high (rather mellow on Icelandic standards) rate of inflation is a collateral damage incurred after the bust of the bubble. The money that was created en masse before and during the fantastic bubble formation before the crash is simply still sloshing around, catching too few goods with inflation as a rather expected result.
Basically, we can interpret it as the classic quantity theory of money doing its work - with a bit of lag as one can really expect (I hope nobody truly beliefs that the rational expectations theory applies: even if the money supply is expanded by x% in time period t, it is impossible to realistically expect that people will boost their price expectations immediately, resulting in a full inflation-feedback within time period t as well. However, over a longer time period, maybe a few years, we can expect the price level to slowly respond in more accordance to the MV=PY theory.)
We can throw the data up graphically to understand them a bit better. Here is the rate of inflation and the relative expansion of M3 over a 5-year-period (instead of the annual measure) since 1886 in Iceland.
5-year inflation and 5-year relative expansion of the money supply (M3). Notice that the axes are the same. Correlation: 0.88. Data constructed from various sources. (OECD, Statistics Iceland, Central Bank of Iceland).
We can see that the bump in 1994-2012 (October value) seems a bit out of place since there is a lack of response in the Consumer Price Index. The same applies to the early 20th century bump and the WW2 spike.
The early 20th century bump can be explained with the fact that the banking system was truly developing fast back then and the proper allocation of money brought supply-side improvements, therefore the CPI did not chase the expansion of the money supply as much. Data might be the reason why as well, we never know with data looking so far into the past. The WW2 spike can be explained by the massive inflow of capital from abroad which did not really enter the circulation but was stacked up in the Central Bank in the form of foreign reserves. They were promptly spent - every pound of them! - after the war on the "second industrialisation" in Iceland when the agriculture and fishing industries were modernised with tractors and trawlers. Of course, we went a bit over our head in that episode and the over-investment was, with the benefit of hindsight, monstrous! But at least that over-investment, despite leading to a currency crash in the early 1950s, left us with tractors and trawlers. Not entirely useless!
But that leaves the early 21st century bulge in M3 without corresponding reaction in the CPI. Lets zoom down onto the last 18 years.
Same as above but zoomed down onto the 1994-2012 period. Notice that the axes are now not the same (inflation is on the right axis).
Now, all of the sudden the rather close (judging from the earlier graph) relationship between 5-year change in money supply and 5-year change in CPI brakes down. So what happened to all that extra money? Well, it's still there. It's just not buying goods... yet. In this respect, it is interesting to look at the ratio between money supply and the monetary value of GDP, i.e. the M/PY ratio (the inverse of the velocity of money).
The ratio between the money supply and the monetary value of total production. Will this ratio fall back down to normal heights through a deletion of money (some people want to "go German" in Iceland and adopt a "New Krona" a la Germany in 1948 when they basically wiped out a large part of the money supply to stop hyperinflation from happening - the "Wirtschaftswunder" happened somewhat as a result of that), through higher nominal prices (inflation) or through more production (GDP growth)?
So what will happen? Will the money just "hang around" there doing nothing or will the monetary value of total production increase? And if it does, will the monetary value of total production increase through higher nominal price level - i.e. will inflation happen - or will it happen through more stuff being manufactured - i.e. will GPD growth happen?
Maybe it wasn't such a good idea to allow the banks to create all that money in the early 2000s!
History and basic economics would dictate an inevitable spike in inflation due to a significant devaluation of the krona. That hasn't happened yet, as the economy and the krona are held in suspended animation of sorts through extensive currency exchange controls. That is, however, not a sustainable way to run an economy and a day of reckoning is inevitable.
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