Monetary and Exchange-Rate Policy

Again in 2005, the krone was stable against the euro at a level close to its central rate.

Danmarks Nationalbank sold foreign exchange net for around kr. 18 billion in 2005 in connection with intervention to stabilise the krone. The foreign-exchange reserve was kr. 212 billion at the end of 2005.

In December 2005 and March 2006, the European Central Bank, ECB, raised its key interest rates. In response to the ECB's interest-rate adjustments, Danmarks Nationalbank raised the lending rate, the discount rate and the interest rate on the current accounts of the monetary-policy counterparties by 0.25 percentage points in December 2005 and by a further 0.25 percentage points in March 2006. In addition, the lending rate was raised by 0.10 percentage points in February 2006 as a consequence of an outflow of foreign exchange. After interest rates were raised on 2 March, the lending rate was 2.75 per cent, while the discount and current-account rates were 2.50 per cent.

At the beginning of 2006, Danmarks Nationalbank made a slight adjustment to the framework for the current-account deposits of the monetary-policy counterparties.

In 2005 four new member states joined ERM II, the European exchange-rate mechanism. The enlargement of the group of ERM II participants does not entail any adjustment of the terms for the Danish krone.

THE FRAMEWORK OF THE FIXED-EXCHANGE-RATE POLICY

The objective of Denmark's monetary and foreign-exchange policy is to keep the krone stable against the euro. Under normal circumstances the Danish monetary-policy interest rates follow those of the ECB, so that a constant interest-rate spread is maintained. In the event of small fluctuations in the exchange rate, Danmarks Nationalbank can intervene in the foreign-exchange market to buy and sell foreign exchange in order to stabilise the krone. If there is a more prolonged tendency for the krone to strengthen or weaken, Danmarks Nationalbank unilaterally adjusts its monetary-policy interest rates.

Denmark has conducted a fixed-exchange-rate policy since 1982, from 1999 within the framework of ERM II, the European exchange-rate mechanism. ERM II stipulates a fluctuation band for the participating currencies vis-à-vis the euro of +/- 15 per cent around the central rate. As a consequence of Denmark's stability-oriented economic policy and the high degree of economic convergence with the euro area, 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 of kr. 746.038 per 100 euro. For a number of years the krone has been stable at a level close to its central rate, cf. Chart 9.

KRONE VIS-À-VIS EURO	Chart 9
Note: Daily observations. Reverse scale. Source: Danmarks Nationalbank.

The fixed-exchange-rate policy entails a clear distribution of responsibility for economic policy. Danmarks Nationalbank must ensure the stability of the krone vis-à-vis the euro. The government conducts fiscal policy and other economic policy with the aim of stabilising the economic development in accordance with the requirements of a fixed exchange rate.

In 2005, four new member states joined ERM II as part of their preparations to adopt the euro: Cyprus, Latvia and Malta joined in May, while Slovakia joined in November, cf. p. 74. The enlargement of the group of ERM II participants to eight does not entail any adjustment of the terms for the Danish krone. The central rates of the participating currencies are determined solely in relation to the euro. The obligation to intervene if a participating currency reaches one of its fluctuation limits rests exclusively on the central bank of the relevant member state and the ECB.

THE ECB' s MONETARY POLICY

The primary objective of the ECB's monetary policy is to maintain price stability. In addition, the monetary policy is to support the general economic policies in the euro area, provided that this does not conflict with the primary objective. The ECB defines price stability as a year-on year increase in the EU Harmonised Index of Consumer Prices, HICP, of below but close to 2 per cent in the medium term. Monetary-policy decisions are based on economic and monetary analyses designed to assess the future risks to price stability. The economic analysis is based on a number of indicators of the real economy and the development in prices, while the monetary analysis among other factors considers growth in lending and the money stock.

Monetary policy in 2005
Consumer prices in the euro area, measured in HICP terms, rose by 2.2 per cent in 2005. The increase was attributable to higher oil prices, which passed through to prices in the autumn especially. Core inflation (HICP excluding energy and food) was around 1.5 per cent in 2005. Economic activity in the euro area picked up in the 2nd half of 2005, after weak development in the 1st half of the year. At its meeting on 1 December 2005, the Governing Council of the ECB decided to reduce monetary-policy stimulation and raised the minimum bid rate from 2.00 per cent to 2.25 per cent, cf. Chart 10. At its meeting on 2 March 2006, the Governing Council decided to raise the minimum bid rate by a further 0.25 percentage points to 2.50 per cent. The interest-rate increase in December was the first in five years, and both increases had been gradually incorporated into money-market interest rates in the preceding months. The ECB stated the risk of higher inflation expectations as a consequence of high oil prices, improved prospects for economic growth and robust rates of growth in the broad monetary aggregate and in lending as the background to the interest-rate increases.

THE MONETARY AND FOREIGN-EXCHANGE POLICY OF DANMARKS NATIONALBANK

In response to the ECB's decision to raise its minimum bid rate, on 1 December 2005 Danmarks Nationalbank announced that the lending rate would be raised from 2.15 per cent to 2.40 per cent with effect from 2 December, cf. Chart 11. The discount and current-account rates were also raised, from 2.00 per cent to 2.25 per cent.

On 17 February 2006, Danmarks Nationalbank raised the lending rate further, to 2.50 per cent. The background was an outflow of foreign exchange in the first weeks of February, among other things as a result of Danish institutional investors' purchases of foreign shares and other securities.

In response to the ECB's raising of the minimum bid rate, on 2 March 2006 Danmarks Nationalbank raised the lending rate from 2.50 per cent to 2.75 per cent with effect from 3 March. At the same time, the discount rate and the current-account rate were raised from 2.25 per cent to 2.50 per cent.

Prior to the raising of interest rates on 2 March, 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 was exceeded, kr. 9.1 billion of the total current-account balance was converted to certificates of deposit.

The krone was stable vis-à-vis the euro in 2005, cf. Chart 9 . In the 1st half-year the krone weakened slightly to a level close to its central rate. Capital flows between Denmark and abroad often entail purchase and sale of foreign exchange against kroner, which can affect the exchange rate in the short term. The krone's weakening in the 1st half of 2005 coincided with an outflow of capital in connection with the insurance and pension sector's purchases of foreign bonds, as well as other sectors' purchases of foreign shares in 2005, cf. Chart 12 . In addition, since May 2005 the yield spread between a 10-year Danish government bond and a German government bond with an equivalent term to maturity has mainly been negative. Net purchases of foreign bonds amounted to kr. 105 billion for the full year, while purchases of foreign shares totalled kr. 79 billion. Non-residents purchased Danish bonds for a net kr. 149 billion in 2005, of which kr. 126 billion was denominated in foreign exchange, however. Non-residents' net purchases of Danish krone-denominated bonds may have contributed to supporting the krone. Typically, however, capital flows in connection with Danish bonds have had a smaller impact on the exchange rate than residents' purchases of foreign bonds and shares.^[1]

Direct investments abroad by Danish business enterprises exceeded non-residents' investments in Denmark by approximately kr. 17 billion in 2005. However, there is no direct correlation between the development in the exchange rate and direct investments, among other things since the impact on the exchange rate is often seen when the investment is announced, not when it subsequently takes place.

In 2005, Danmarks Nationalbank sold foreign exchange net for around kr. 18 billion in connection with intervention to stabilise the exchange rate, cf. Table 3. After value adjustments, the foreign-exchange reserve was kr. 212 billion at end-2005, but decreased to kr. 182 billion at the end of February 2006 as a result of intervention.

Danmarks Nationalbank's monetary-policy instruments
On 2 January 2006, Danmarks Nationalbank adjusted the framework for the current-account deposits of the monetary-policy counterparties. The overall current-account limit was raised from approximately kr. 20 billion to approximately kr. 25 billion. A large part of the increase was attributable to simplification of the system so that the counterparties are now allocated standard limits. This entails that small counterparties are generally allocated higher limits than previously. The raising of the overall current-account limit should also be viewed against the background of the general economic development since the last adjustment of the current-account limits in 2003. No counterparties' current-account limits were reduced in connection with the adjustment. The current-account-limit system is described in Box 2.

There have been no changes in the other monetary-policy instruments in 2005. Danmarks Nationalbank's monetary-policy instruments are reviewed in Box 3.

The extent of monetary-policy lending has increased in recent years. To a high degree the borrowing reflects an increase in the holdings of certificates of deposit of the banks and mortgage-credit institutes, cf. Chart 13 . Interest in certificates of deposit has among other things increased in step with an increasing volume of payments related to the refinancing of mortgage-credit loans. Certificates of deposit are part of the liquidity reserve of the banks and mortgage-credit institutes. Danmarks Nationalbank thus contributes liquidity in connection with extraordinary market operations by repurchasing certificates of deposit. Certificates of deposit may also be traded among or mortgaged by the banks and mortgage-credit institutes in order to obtain liquidity via the money market. Since the lending rate and the rate of interest on certificates of deposit are identical, there are no interest costs on borrowing to finance purchase of certificates of deposit.

THE MONEY MARKET AND THE SHORT-TERM INTEREST RATES

In 2005, interest rates in the Danish money market^[2] generally followed the money-market interest rates of the euro area. The average spread between the short-term Danish money-market interest rates and those of the euro area was around 5 basis points, cf. Chart 14. This was slightly below the spread between Danmarks Nationalbank's lending rate and the ECB's marginal rate. As in previous years, the spread was influenced by the fact that many euro area banks adjusted their balance sheets at year-end. Consequently, the euro-area money-market interest rates rose towards the end of the year as maturities began to extend into the next year.^[3] However, the effect was less pronounced in 2005 than in 2004. The spread widened in February 2006 after Danmarks Nationalbank raised the lending rate and the rate of interest on certificates of deposit by 0.10 percentage points.

The short-term money-market interest rates in the euro area were stable until the end of September. Due to expectations of higher interest rates, the yield curve in the euro money market steepened towards the end of 2005.

Cibor (Copenhagen Interbank Offered Rate) is a reference interest rate for uncollateralised krone-denominated lending in the inter-bank market. A number of banks report interest rates to Danmarks Nationalbank, which calculates and announces Cibor on a daily basis. The rates reported by the individual banks are published by the Danish Bankers Association. In April 2005, the group of banks participating in the fixing of Cibor was extended to include four foreign banks, i.e. a total of 12 banks, and the number of maturities for which Cibor rates are fixed was increased by six to a total of 14 maturities. The purpose was to ensure the continued credibility and recognition of Cibor.

The banks' interest rates
Over the year, the banks' average lending rates fell by around 0.4 per cent, while the deposit rates were virtually unchanged, cf. Chart 15. The narrowing of the spread between the lending and deposit rates reflects the increasing volume of loans against real property as collateral, among other factors.