Macroeconomic forecast for 2014 -2016
Islandsbanki Research has published a new macroeconomic forecast for 2014 -2016
2014 – A year of equilibrium and sound GDP growth
The economic outlook for Iceland is quite positive at present. We forecast year-2014 GDP growth at 3.2%, which is broadly in line with last year’s growth rate as reflected in preliminary figures from Statistics Iceland (SI). This year, however, the composition of Iceland’s GDP growth will be considerably different than last year’s, which was driven by net trade. According to our forecast, this year’s growth will be driven by private consumption, investment, and exports. On the other hand, we expect imports to outpace exports this year, making for a negative contribution from net trade to GDP growth.
The slack that developed in the economy with the onset of the crisis in 2008 has narrowed considerably, as can be seen in labour market statistics, including the steady decline in unemployment from the 2010 peak. We expect the spare capacity in the economy to continue narrowing and the labour market to strengthen further. According to our forecast, inflation will remain below the Central Bank’s (CBI) inflation target for most of the year, the exchange rate will remain relatively stable, and the CBI’s Monetary Policy Committee (MPC) will lower the policy rate in the first half of the year but keep it unchanged in the second half. The year will therefore be characterised an unusual level of stability in a number of economic variables.
GDP growth outlook good for 2015 and 2016
We forecast output growth at 3.3% next year, well above the 30-year average and well in excess of the IMF’s forecast of 2.3% for industrialised countries in 2015. If the forecast materialises, GDP will have surpassed year-2008 GDP at fixed prices by 2015 – seven years after the onset of the twin banking and currency crisis. By 2016, per capita GDP will have risen back to the pre-crisis peak.
According to the forecast, GDP growth will be relatively broad-based in 2015, as it is this year. We expect private consumption to continue growing relatively rapidly, albeit somewhat slower than in 2014. We also expect investment growth to pick up in 2015, business investment in particular. Furthermore, we project relatively strong growth in goods and services exports, but we assume that import growth will overtake it and that the contribution of net trade to GDP growth will remain negative.
We expect GDP growth to slow down slightly in 2016; however, the uncertainty in the forecast increases further out the horizon. We forecast output growth at 2.4% in 2016, owing mainly to weaker growth in investment and exports. Domestic demand and exports will continue to grow, however. The investment level will rise throughout the forecast horizon, although it has been extremely low in the wake of the crisis. As a result, national saving will also increase during the period.
ISK exchange rate stable
A number of forces will pull the exchange rate in different directions in the near term. First of all, it is natural that the real exchange rate should rise as spare capacity disappears from the economy, as is forecast to happen in the near future. According to our inflation forecast, the rise in the real exchange rate will occur to some degree through higher inflation relative to trading partner countries during the period, although the nominal exchange rate will rise somewhat as well.
Offsetting this is the balance of payments problem that is revealed by a comparison of the forecasted underlying current account balance and the expected capital outflows due to foreign debt service during the forecast horizon. In view of this problem and the fact that inflation is at target, it is quite likely that the CBI will want to see the nominal exchange rate rise, at least in the near term. Although the CBI cannot affect long-term developments in the real exchange rate, it can make some impact on it in the short and medium term. The bank will probably elect to use the mismatch in foreign exchange flows that would otherwise have strengthened the ISK in order to shore up its non-borrowed reserves. We expect the above-described forces to offset one another, with the result that the ISK will hold broadly steady at the current level throughout the forecast horizon.
Higher inflation and policy rate in the cards
Inflation will remain below the CBI’s inflation target for most of the year, according to our forecast, and then begin to inch upwards as a positive output gap develops. We forecast inflation at 2.9% in 2015 and 3.1% in 2016, owing primarily to rapid housing inflation and domestic cost increases. The effects of the recent ISK appreciation will subside over the course of 2014. Inflation should be slightly below wage increases, however, and real wages will therefore continue to increase, according to the forecast. Inflation will also be outpaced by house prices; therefore, real house prices will continue to rise, albeit somewhat more slowly than in the recent past.
We expect the MPC to lower the CBI’s policy rate by 0.25 percentage points before mid-year. As the output gap develops, however, we expect the MPC to raise the policy rate by 0.75 percentage points next year, in three increments, bringing it to 6.5% by year-end 2015. We then expect one 0.25-point increase in 2016. We assume that long-term nominal interest rates will rise during the forecast horizon, due to the increase in the policy rate and to elevated inflation expectations. On the other hand, we expect little change in long-term real rates, as these two factors will counteract one another.
Our forecast is based on the assumption that the capital controls will be eased during the forecast horizon in such a way as to avoid upsetting foreign exchange market stability. It is conceivable that some steps will be taken towards liberalisation, in line with Government declarations. If large steps are taken, it can be assumed that they will call for a monetary policy response in the form of a higher policy rate and a wider interest rate spread in order to protect the exchange rate. If this occurs, it will tend to raise our forecast for long-term rates.
Declining trade surplus
The export growth we forecast for the near term will be driven by a strong increase in services exports and continued growth in marine product exports. The trade surplus, however, will decline relative to GDP over the course of the forecast horizon. On the whole, we project that the surplus on goods and services trade will measure 6.0% of GDP this year and then taper off, falling to 4.4% of GDP by 2016. The main contributor here is import growth, which will exceed export growth each year during the forecast horizon. The surge in imports is due primarily to domestic demand for both consumer and investment goods.
As the trade surplus declines, the current account surplus will narrow as well. Nonetheless, we expect a surplus on the underlying current account balance (i.e., adjusted for the settlement of the old banks’ estates) throughout the forecast horizon. We forecast the underlying current account surplus at 2.6% of GDP this year and 1.0% of GDP in 2016. As a result, trade-related foreign exchange inflows will taper off slightly in coming years, although it should be borne in mind that the declining current account surplus is due in part to increased importation of goods for industrial investment, which are partly financed abroad and therefore do not require foreign exchange outflows.
ISB Research Macroeconomic Forecast