Monetary and Foreign-Exchange Policy

In 2006, the krone remained stable against the euro at a level close to the central rate.

Inconnectionwithinterventionintheforeign-exchangemarket Danmarks Nationalbank sold foreign exchange net for kr. 34 billion in 2006. Most of the intervention took place in connection with the outflow of foreign exchange in February, when Danmarks Nationalbank unilaterally raised the lending rate by 0.1 percentage point. There was no intervention in the first two months of 2007. The foreign-exchange reserve was kr. 178 billion at the end of February 2007.

During 2006 the ECB raised its key interest rate on five occasions by a total of 1.25 percentage points. In March 2007 the ECB raised the interest rate by a further 0.25 percentage points. In all cases these interest-rate increases were followed by Danmarks Nationalbank. After the interest-rate increase in March 2007, Danmarks Nationalbank's lending rate was 4.0 per cent, and the spread to the ECB's minimum bid rate was 0.25 percentage points.

At the beginning of 2006, Danmarks Nationalbank made a slight adjustment to the framework for the current-account deposits of the banks and mortgage-credit institutes. No changes were made to the other monetary-policy instruments in 2006. At the beginning of 2007, minor adjustments were made to the framework for the provision of collateral for monetary-policy loans from Danmarks Nationalbank.

In May 2007, the maturity of Danmarks Nationalbank's monetary-policy lending and certificates of deposit is adjusted from 14 to 7 days. The purpose of the adjustment is to reduce the strong fluctuation in the day-to-day interest rate that can arise prior to expected interest-rate adjustments.

On 1 January 2007, Slovenia adopted the euro and therefore ceased to participate in ERM II. The reduction of the number of ERM II participants does not entail any adjustment of the terms for the Danish krone.

THE FRAMEWORK FOR THE FIXED-EXCHANGE-RATE POLICY

The objective of Denmark's monetary and foreign-exchange policy is to keep the krone stable against the euro. The objective of the euro area's monetary policy is to keep inflation below, but close to, 2 per cent. Holding the krone stable against the euro creates a framework for low, stable inflation in Denmark in the slightly longer term.

As a consequence of the fixed-exchange-rate policy, Danmarks Nationalbank's interest rates normally follow those of the European Central Bank, ECB, for the euro area. Danmarks Nationalbank smoothes minor fluctuations in the krone rate by intervening in the foreign-exchange market by buying and selling foreign exchange against kroner. If there is a more prolonged tendency for the krone to strengthen or weaken, Danmarks Nationalbank unilaterally adjusts its interest rates.

The official interest rates are used only to stabilise the krone, and not for other purposes. Other factors besides the krone rate – e.g. the cyclical position – thus cannot be part of the monetary-policy deliberations. A stability-oriented fiscal policy is therefore required in order to avoid overheating, as well as high unemployment.

ERM II is the formal framework for Denmark's fixed-exchange-rate policy. Denmark participates in ERM II at a central rate of kr. 7.46038 per euro. As a consequence of Denmark's stability-oriented economic policy, a narrower fluctuation band was agreed when Denmark joined ERM II, whereby the krone may fluctuate by +/- 2.25 per cent around the central rate. The standard fluctuation band in ERM II is +/- 15 per cent. The euro is at the core of ERM II, and the other participating currencies are subject to central rates against the euro, but not against each other. Should a currency reach a fluctuation limit, both the ECB and the relevant national central bank must ensure that the exchange rate remains within the fluctuation band. The other participants have no intervention obligation. Danmarks Nationalbank would thus not have to intervene in the foreign-exchange market if one of the other currencies in ERM II came under pressure.

Throughout 2006, the krone was stable at a level close to the central rate, cf. Chart 9, in accordance with Danmarks Nationalbank's objective to hold the krone close to the central rate. For most of the period since the introduction of the euro in 1999 it has been possible to keep the krone stable without any major monetary-policy or foreign-exchange-policy intervention by Danmarks Nationalbank.

KRONE VIS-À-VIS EURO	Chart 9
Note: Reverse scale.

In 2006, the group of ERM II participants numbered Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia and Slovenia, besides Denmark and the ECB. Slovenia adopted the euro on 1 January 2007, cf. p. 76, and therefore ceased to participate in ERM II. The change in the group of ERM II participants does not entail any adjustment of the terms for the Danish krone. In connection with Slovenia's withdrawal from ERM II and the simultaneous enlargement of the EU with Bulgaria and Romania, minor technical adjustments were made to the central-bank agreement on ERM II.^[1] 

THE ECB'S MONETARY POLICY

The objective of the ECB's monetary policy is to maintain price stability, with inflation below, but close to, 2 per cent in the medium term. Monetary-policy decisions in the euro area are based on detailed economic and monetary analyses designed to assess the future risks to price stability.

In 2006, consumer prices in the euro area, measured in terms of the EU Harmonised Index of Consumer Prices, HICP, rose by 2.2 per cent against 2005. Energy prices fell in the 2nd half of 2006, bringing inflation below 2 per cent for the first time since the beginning of 2005. Throughout 2006, core inflation (the year-on-year increase in HICP excluding energy and food) was around 1.5 per cent. During 2006 the economic upswing in the euro area became increasingly apparent from the real-economic indicators, with sustained robust growth in both money and credit. The ECB's projections of growth in the euro area in 2006 and 2007 were revised upwards during 2006, and throughout the year the ECB stated in its press releases that the economic development entailed upside risks to price stability in the medium term.

During 2006, the ECB continued the adjustment of the level of its key interest rate, the minimum bid rate, which began in December 2005. On 2 March 2006, the ECB raised the minimum bid rate by 0.25 percentage points to 2.5 per cent. On five further occasions during 2006 and the beginning of 2007 the ECB's minimum bid rate was raised by 0.25 percentage points. The interest-rate decisions took place on 8 June, 3 August, 5 October and 7 December 2006, and 8 March 2007. The ECB stated a higher inflation risk, against the background of the favourable economic outlook for the euro area, as the basis for the interest-rate decisions. In addition, it was noted that money and credit growth was still strong, and that there was an increased risk of oil-price increases spreading to other areas of the economy, thereby affecting wage formation. The interest-rate increase in March 2007 brought the minimum bid rate up to 3.75 per cent, cf. Chart 10.

In recent years the ECB has sought to prepare the general public for upcoming interest-rate adjustments via its communication of monetary policy. All of the ECB's interest-rate increases in 2006 were therefore expected and had been discounted in the money-market interest rates in the months preceding the interest-rate increases in both the euro area and Denmark.

THE MONETARY AND FOREIGN-EXCHANGE POLICY OF DANMARKS NATIONALBANK

Monetary and foreign-exchange policy
At the beginning of 2006, cross-border securities transactions (portfolio investments) entailed an outflow of capital from Denmark, cf. Chart 11.^[2] In the first part of February 2006, the krone weakened to the lowest level vis-à-vis the euro since 2001. For February overall, portfolio investments entailed a net capital outflow of kr. 59 billion. The outflow of foreign exchange from Denmark in February could be attributed to factors such as purchases of foreign stocks by Danish institutional investors. Furthermore, the outflow of capital was related to the settlement of TDC's acquisition by a number of foreign private equity funds. A considerable proportion of TDC's previous shareholders were non-residents who did not reinvest the proceeds in Danish securities.^[3] In February overall, the capital outflow as a result of trading in Danish stocks totalled kr. 43 billion.

There was no intervention in the foreign-exchange market in January 2006, but in the first part of February Danmarks Nationalbank sold foreign exchange for a total of kr. 34 billion in order to stabilise the krone. On 17 February 2006, the lending rate was raised by 0.1 percentage point to 2.5 per cent, while the discount rate and the current-account rate remained unchanged. Danmarks Nationalbank's unilateral interest-rate increase widened the spread to the ECB's minimum bid rate from 0.15 to 0.25 percentage points. The spread to the ECB's marginal rate widened equivalently, but was, however, lower, cf. p 40.

In absolute terms, the intervention amount in February 2006 was at the level of the substantial interventions during the currency crisis in the summer of 1993. The modest interest-rate increase was nevertheless sufficient to stabilise the krone. This reflects considerably larger payment flows between Denmark and abroad today than at the beginning of the 1990s. As a result, capital flows of a magnitude previously only observed during foreign-exchange crises can now be seen even when the foreign-exchange markets are stable.^[4] The development in February moreover reflects that even very small adjustments of Danmarks Nationalbank's monetary-policy interest rates can be sufficient to curtail large capital flows.

The yield spread between Danish and German 10-year government bonds was slightly negative for most of the 2nd half of 2005. After Danmarks Nationalbank's unilateral interest-rate increase, the long-term yield spread widened to around 0.1 percentage point during the spring of 2006, and remained relatively stable around this level until August. The spread then narrowed again in the light of such factors as increasingly positive expectations of Denmark's government-budget surplus. The narrowing of the yield spread led to a certain outflow of capital, for example due to residents' net purchases of foreign bonds.

For 2006 overall, portfolio investments gave a net capital outflow of kr. 104 billion in total. In recent years, there has been a general tendency for net capital outflows from portfolio investments. The underlying factors include institutional investors' substantial placement requirement due to increased savings in investment associations and as pension contributions to build up labour-market pensions. In order to optimise returns, taking due account of the risk and the statutory rules to which investors are subject, the institutional investors place funds in both Danish and foreign securities.^[5] The capital outflows from portfolio investments observed in recent years are therefore partly attributable to structural factors.

In 2006, Danmarks Nationalbank sold foreign exchange net for a total of kr. 34 billion in order to stabilise the krone, cf. Table 3. Most of the intervention took place in February 2006. During the rest of the year Danmarks Nationalbank only intervened on a few occasions and for very modest amounts. In 2006 the number of days with intervention in the foreign-exchange market was the lowest since 2001.

At the end of February 2007, the foreign-exchange reserve was kr. 178 billion, compared to kr. 212 billion at end-2005. The reduction is primarily attributable to Danmarks Nationalbank's intervention in the foreign-exchange market. In addition, the central government redeemed foreign-exchange-denominated loans net for just over kr. 10 billion in 2006. 

The ECB's interest-rate increases in 2006 and the beginning of 2007 were followed by equivalent increases of Danmarks Nationalbank's interest rates, which were in line with market expectations. Prior to the raising of interest rates on 2 March 2006, a number of banks and mortgage-credit institutes deposited large amounts to their current accounts with Danmarks Nationalbank. As this meant that the overall limit for current-account deposits of kr. 25 billion was exceeded, kr. 9.1 billion of the total current-account balance was converted to certificates of deposit. This was the first conversion due to the development in the current-account deposits of the banks and mortgage-credit institutes since the present current-account-limit system was introduced in June 1999. The conversion had no adverse effect on the daily settlement of payments.

After the interest-rate increase in March 2007, Danmarks Nationalbank's lending rate was 4.0 per cent, and the spread to the ECB's minimum bid rate was 0.25 percentage points.

Net position of the banks and mortgage-credit institutes and their use of the monetary-policy instruments
The net position of the banks and mortgage-credit institutes vis-à-vis Danmarks Nationalbank amounted to kr. 18 billion at end-2006. The net position consisted of current-account deposits for kr. 9 billion, certificates of deposit for kr. 163 billion and monetary-policy loans for kr. 154 billion, cf. Table 4. The net position totalled kr. 85 billion at end-2006.

The decrease in the net position of the banks and mortgage-credit institutes by kr. 67 billion during 2006 in part reflected Danmarks Nationalbank's net intervention sales of foreign exchange against kroner to the banks for kr. 34 billion. In addition, government finances reduced the net position of the banks and mortgage-credit institutes by kr. 31 billion. The background is that towards the end of the year there were large tax receipts and smaller disbursements than expected for e.g. unemployment benefits. The decline in the net position in particular reflected a reduction of holdings of certificates of deposit among the banks and mortgage-credit institutes, and an increase in monetary-policy lending.

The net position can be subject to relatively strong fluctuations from day to day. Such fluctuations influence the day-to-day liquidity management, but have no consequences for monetary policy. A net position close to zero can switch from positive to negative and vice versa, as observed in several periods of 2000. Since Danmarks Nationalbank's interest rates on certificates of deposit and monetary-policy loans are identical, the banks and mortgage-credit institutes can borrow from and make deposits with Danmarks Nationalbank at the same rate of interest. This ensures that Denmark's interest-rate policy, and thereby the krone rate, is unaffected by either a positive or a negative net position. As a consequence, Danmarks Nationalbank has no targets for the size of or the sign preceding the net position.

Monetary-policy and foreign-exchange-policy instruments and operations
On 2 January 2006, Danmarks Nationalbank adjusted the limits for current-account deposits by the banks and mortgage-credit institutes. The overall current-account limit was raised from approximately kr. 20 billion to approximately kr. 25 billion, primarily as a result of simplification of the system whereby all banks and mortgage-credit institutes are now subject to a standard limit of kr. 100 million. Banks and mortgage-credit institutes which have extensive activity in the money market, and are therefore key contributors to the smooth exchange of liquidity, receive a supplement to the standard limit. The adjustments entail generally higher limits for the smaller banks and mortgage-credit institutes than before. In addition, the raising of the overall current-account limit should be viewed in the light of the economic development since the previous adjustment in 2003. The adjustment did not entail reduction of the current-account limit for any bank or mortgage-credit institute.

There were no changes to the other monetary-policy and foreign-exchange-policy instruments in 2006.

At the beginning of January 2007, a number of adjustments were made to the rules for provision of collateral for monetary-policy loans from Danmarks Nationalbank, cf. p. 68.

The maturity of Danmarks Nationalbank's monetary-policy lending and certificates of deposit has so far been 14 days. As a result, the Danish day-to-day interest rate can fluctuate considerably in periods when the ECB is expected to raise its interest rates, cf. Box 2. In order to reduce these fluctuations, as from 3 May 2007 Danmarks Nationalbank adjusts the normal maturity of monetary-policy lending and certificates of deposit to 7 days. The same maturity of 7 days applies to monetary-policy loans in the euro area.

MATURITY OF THE MONETARY-POLICY INSTRUMENTS AND FLUCTUATIONS IN THE OVERNIGHT INTEREST RATE IN THE MONEY MARKET	Box 2
In recent years, there have been cases of strong fluctuation in the day-to-day money-market interest rate in periods when interest rates in the euro area – and thus also in Denmark – were expected to increase. The banks and mortgage-credit institutes are reluctant to tie up liquidity for 14 days by purchasing certificates of deposit if interest rates are expected to be raised before the certificates of deposit mature. In this situation, there will be ample liquidity in the money market, and very low day-to-day interest rates. Since current-account deposits are subject to limits, the day-to-day interest rate can even fall below the level of the current-account rate, cf. the red circles in the Chart. On the other hand, in periods when interest rates in the euro area and Denmark are expected to be lowered, there will be considerable interest in buying 14-day certificates of deposit that mature after the time that interest rates are expected to be lowered. This can lead to a shortfall of liquidity in the money market and large increases in the day-to-day interest rate, cf. the green circles in the Chart.1
DANMARKS NATIONALBANK'S CURRENT-ACCOUNT RATE AND THE DAY-TO-DAY INTEREST RATE IN THE MONEY MARKET
Note: The overnight interest rate is the tomorrow/next interest rate.
By changing from 14-day to 7-day maturities both loans and certificates of deposit will normally mature on the day that any interest-rate change takes effect and will therefore not overrun an interest-rate adjustment. This will contribute to reducing the large fluctuations in the day-to-day interest rate.
1 The strong increase in the day-to-day interest rate at the end of November 2006 should be viewed against the background that Danmarks Nationalbank gave access to extraordinary purchases of certificates of deposit at short maturities. The certificates of deposit were due to mature in the first week of December 2006, when interest rates in the euro area were expected to be raised. This resulted in strong demand for certificates of deposit at the end of November, and thereby tight liquidity and high interest rates in the money market.

Box 3 outlines the monetary-policy and foreign-exchange-policy instruments and operations.

THE MONEY MARKET AND SHORT-TERM INTEREST RATES

Danmarks Nationalbank's interest rates determine the short-term interest rates in the money market, i.e. the interbank market for krone-denominated lending and deposits with a maturity of up to one year. In 2006, the interest rates in the Danish money market generally matched the development in the money-market interest rates in the euro area. In recent years, the spread between the short-term Danish and euro-area money-market interest rates has been relatively stable on the downside of the spread between Danmarks Nationalbank's lending rate and the ECB's minimum bid rate, cf. Chart 12. The primary underlying factor is that the rate of interest for allotment of liquidity to the banks in the euro area at the weekly tenders (the ECB's marginal rate) normally slightly exceeds the minimum bid rate.

In recent years, as adjustable-rate loans have gained ground, the money-market interest rates have become more important for households and business enterprises. At the end of 2006, loans subject to interest-rate adjustment within one year accounted for just over one third of the total lending by the mortgage-credit institutes. The rate of interest at which 1-year mortgage-credit loans were refinanced in December 2006 was around 1.2 percentage points above the interest rate in December 2005. This generally matches the development in the 1-year money-market interest rates.

The banks' average deposit and lending rates likewise reflected the development in the monetary-policy interest rates during 2006, cf. Chart 13. The close relation between changes in the banks' interest rates vis-à-vis their customers and adjustments to the discount rate is attributable to the fact that a large proportion of the banks' deposits and lending is subject to variable interest-rate terms.