We forecast a 0.9% drop in the CPI in January

We project that the consumer price index (CPI) will fall 0.9% month-on-month in January. If this forecast materialises, headline inflation will fall from 0.8% to 0.6%, thereby remaining below the lower deviation limit for the Central Bank’s (CBI) inflation target. If these projections are borne out, headline inflation will be at its lowest since December 1994. 

Short-term inflationary pressures are extraordinarily low, and we expect very low inflation figures in the months to come. Actually, we expect inflation to remain below the lower deviation limit for the 2.5% inflation target over the first half of the year and below the target for the entire year. We then expect it to rise as the economy picks up, although it will remain fairly close to target. Statistics Iceland (SI) will publish the CPI for January at 9:00 hrs. on 29 January. 

Tax system changes a major factor

The changes in public levies that took effect at the beginning of 2015 will make a strong impact on many components of the CPI. The strongest impact will be on electrical equipment, stereo equipment, and television sets, where the excise tax cancellation and the reduction of the upper VAT bracket from 25.5% to 24.0% will combine to lower prices, and on unsweetened foods, indoor heating, books and newspapers, hotel accommodation, and others, where the increase in the upper VAT bracket will raise prices by nearly 4%, other things being equal. However, estimating the overall effects of the tax changes is complicated by the impact of seasonal sales, which affect items such as clothing, footwear, electrical equipment, and television sets, and the fact that the excise tax cancellation had already been passed through to the price of many goods by the end of the year. Our rough estimate of the total effect of the changes in public levies indicates that they will lower the CPI by 0.2-0.3% in January. 

Strong sales effects, as usual

 As is customary, winter sales will exert a strong downward pull on the CPI in January. We expect this year’s sales effects to be broadly similar to those in recent years. Furthermore, the reduction in the upper VAT rate and, in some instances, the excise tax cancellation as well, will mean that those goods categories that usually show the strongest sales effects will see prices fall even more than usual this year. We project the CPI effect of reductions in clothing and footwear prices at -0.54%, and for furniture, electrical equipment, stereo equipment, and television sets, we estimate it at -0.17%.

Petrol and airfares fall markedly

The freefall in global oil prices continues unabated, begetting the largest decline in domestic petrol prices in a single month in the history of Statistics Iceland’s (SI) figures, which extend back to 1997. The impact of global oil prices is compounded by the reduction in the upper VAT rate. Gasoline prices have fallen by an average of ISK 23 and diesel fuel by ISK 21 since SI’s early December measurement. We estimate the CPI effect of declining petrol prices at -0.40%. 

International airfares rose sharply in December, as price fluctuations at peak times such as Christmas and the New Year show more strongly in the monthly values for the air travel component because of new calculation methods adopted by SI. Our survey indicates that airfares will taper off again strongly in the January CPI measurement (-0.36% CPI effect). 

Food, beverages, and housing component rise

There are two main CPI components that pull against the above-described downward impact in January. Food and beverage prices rose sharply at the turn of the year, owing to the increase in the lower VAT bracket. The cancellation of the sugar tax mitigates the effect somewhat, however, and we estimate the CPI effect for the component as a whole at +0.34%. 

The rise in the housing component also raises the CPI by 0.34%, according to our forecast. The most important contributor here is a 4.5% increase in electricity and heating prices (0.15% CPI effect). Our survey indicates that imputed rent, which largely reflects the market value of residential housing, will rise by 0.7% in the January CPI measurement (0.10% CPI effect). Other items such as waste collection fees and paid rent will also rise, according to our projections. 

Price list increases often have a strong upward impact on the January CPI. This year, however, it appears that such increases will be modest, and this contributes to the steep decline in the CPI during the month. 

CPI to rise modestly in coming months

We expect the CPI to rise by 0.4% in February, 0.4% in March, and 0.2% in April. According to this, the CPI will decline by 0.1% in Q1, and inflation will average 0.5% for the quarter. End-of-sale effects will be strong in February and March, as usual, although the final effects of the excise tax cancellation on electrical equipment and similar items will probably offset them somewhat. On the other hand, we expect further declines in petrol prices in February, as the effects of the past weeks’ 15% drop in foreign oil prices have yet to be felt. 

Inflation below target throughout 2015 

 We expect inflation to gain pace steadily as 2015 progresses and that it will measure 2.0% at the end of the year. In 2016 the pace will increase yet again, to about 2.8% for the year as a whole. The main drivers of inflation will be relatively rapid wage increases in the near term, continued rises in real house prices, and elevated imported inflation. Inflation will be close to inflation target at the end of the forecast horizon, however, and if our forecast materialises, Iceland will see its longest period of low, stable inflation in a decade and a half. 

The uncertainty in the forecast is concentrated on the upside, however, for two reasons. First of all, the wage settlements in upcoming months could generate more rapid rises in nominal wages than we expect, and second, we base our forecast on the assumption that the exchange rate will remain close to its current level, as the ISK has been unusually stable in recent quarters. This could change, however, if steps taken towards lifting the capital controls are accompanied by increased exchange rate volatility and elevated risk of considerable foreign exchange outflows, at least temporarily. 

Inflation forecast