Macroeconomic forecast: Robust growth ahead

With strong output growth in the past few years, the Icelandic economy has shaken off the lion’s share of the slack that developed after the 2008 collapse. The economy has been rebalanced, and both inflation and the exchange rate have been extraordinarily stable this year. Unemployment continues to fall, and the labour market situation is improving. Private sector balance sheets are strengthening, real disposable income is increasing, asset prices are on the rise, and debt ratios are falling. All of these are signs of economic recovery. 

The overall GDP growth outlook is good, in our opinion, and we expect the economy to keep gaining strength in coming years. We forecast output growth for this year at 3.1% (as compared with 3.5% in 2013), followed by 3.2% in 2015 and 2.9% in 2016, and expect private sector financial conditions to continue improving over the same period.

The economic outlook is determined in part by the level of success in maintaining stability, which in turn depends on the effectiveness of fiscal and monetary policy. Stability also depends on how successfully the authorities resolve the systemic problems that necessitated the capital controls and whether the controls can be lifted without sacrificing stability. It can be said that stability is both one of the cornerstones of our forecast and one of the main uncertainties in it. 

The economic upswing of recent years has rested in large part on increased utilisation of natural resources. We expect that trend to continue, although the composition will change. Growth based on Iceland as a tourism destination will moderate, although this form of natural resource utilisation will remain an important contributor to GDP growth during the forecast horizon. On the other hand, investment will grow, as will exports based on increased resource utilisation. 

In 2013, GDP growth was driven primarily by net trade; that is, strong export growth accompanied by weak import growth. We expect a different pattern during the forecast horizon. This year’s growth will be based on a strong upturn in domestic demand, which will continue to grow quite rapidly over the next two years, although the rate will slow somewhat over the period. This growth in domestic demand will be accompanied by increased imports, which will result in a negative contribution of net trade to GDP growth throughout the forecast horizon. 

The output slack has all but vanished from the Icelandic economy. According to our forecast, GDP growth will be strong enough in the next two years that an output gap will begin to develop, triggering a rise in inflation and causing the Central Bank (CBI) to respond by raising the nominal policy rate. In another side effect of this robust GDP growth, unemployment will decline further and the labour market situation will improve.  

Macro forecast October 2014