We forecast an unchanged CPI in October

We project that the consumer price index (CPI) will remain unchanged month-on-month in October. If this forecast materialises, twelve-month inflation will likewise remain unchanged, at 1.8%. 

The inflation outlook for this year is positive, as before, and has improved steadily in recent months. We now expect inflation to remain below the Central Bank’s (CBI) 2.5% inflation target until mid-2015 and then rise thereafter as the economy rallies, yet remain close to target. Statistics Iceland (SI) is scheduled to publish the October CPI at 9:00 hrs. on 29 October.

Petrol and electrical equipment prices decline

Falling petrol prices are the single strongest determinant of our October forecast. Global carbon fuel prices have fallen sharply in recent weeks, causing a 3.8% drop in domestic petrol prices (-0.16% CPI effect) since the publication of SI’s September CPI measurement. The excise tax reduction set to take effect at the beginning of 2015 has already affected the price of large home appliances, television sets, and stereo equipment, with an estimated CPI effect of -0.04%. And finally, hotel and guesthouse accommodation prices declined somewhat in October (-0.03% CPI effect), reflecting the end of the peak tourist season. 

Smaller rise in housing component

The housing component of the CPI has been the main driver of inflation in the recent term, with CPI inflation excluding housing measuring only 0.4% in September. On the other hand, it appears that the effect of the housing component will be weaker than usual in October, owing to signs of slower increases in house prices and a 0.4% decline in maintenance costs since the publication of the September CPI. We expect the housing component as a whole to rise by 0.2% (0.05% CPI effect). 

We expect international airfares to rise somewhat in October (0.03% CPI effect), although the increase will only compensate to a limited degree for the steep drop in August and September. Other components will change less markedly, raising the CPI by 0.12% combined in October. 

Inflation to remain below target through the winter

We expect the CPI to rise by a total of 0.4% in Q4, with the increase distributed more or less equally over November and December. According to this forecast, inflation will measure 1.3% at the end of the year. This lack of short-term inflationary pressure is due to a number of factors, including extremely low imported inflation, as the ISK is stable and foreign prices of various goods such as food and petrol have fallen significantly in the recent term. Furthermore, wage pressures remain relatively modest, which we attribute to the moderate nominal pay increases negotiated in the early 2014 wage settlements. 

The outlook is for inflation to rise steadily as 2015 progresses, rising above the CBI’s 2.5% inflation target in the latter half of the year. Presumably, increased economic activity will be reflected in swifter pay hikes and continued increases in real house prices. Inflation will remain close to target, however, and if our forecast materialises, 2014-2016 will be the longest period of inflation within the CBI’s tolerance limits (1.0 – 4.0%) since the adoption of the inflation targeting regime in spring 2001. We project inflation to measure 3.0 in December 2015, and to average 2.4% in 2015 and 2.8% in 2016. 

Our long-term forecast is based on several assumptions: that house prices will rise by 5-7% per year throughout the forecast horizon, that wage hikes will accelerate markedly in the near future as tension grows in the labour market, and that the ISK exchange rate will remain broadly unchanged. It should be noted, however, that the uncertainty in the forecast is concentrated on the upside. Wage increases could easily exceed expectations, and the ISK is likelier to weaken than strengthen as time passes, although the CBI appears ready to take action to promote exchange rate stability in the near term. 

Inflation forecast