OUR FORECAST: CPI to rise 0.9% in March

We project that the consumer price index (CPI) will rise by 0.9% month-on-month in March. If this forecast materialises, headline inflation will rise from 0.8% to 1.4%, bringing to an end – for the present, at least – the short episode of inflation below the lower deviation threshold of the Central Bank’s (CBI) inflation target. However, inflation will remain below the target itself, which is 2.5%. 

The outlook has deteriorated somewhat, even though short-term inflationary pressures are still limited. We expect inflation to be below target for most of 2015 and then rise above it as the economy gets moving, although it will remain fairly close to the target. Statistics Iceland (SI) will publish the March CPI at 9:00 hrs. on 27 March. 

House prices up sharply

The largest single cause of the hefty rise in the CPI in March is imputed rent, which largely reflects developments in residential house prices. This component also explains to a large degree the difference between our current forecast and our preliminary forecast for March. Our survey suggests that, based on a three-month moving average with a one-month time lag (SI’s method of calculation), house prices have risen by just over 2.0% month-on-month (0.29% CPI effect). If this forecast is borne out, it will have been the most rapid MoM rise in this component since late 2007. 

House prices have risen swiftly in recent months, after keeping a relatively modest pace for most of 2014. This change in the housing market is probably due to the Government’s mortgage debt relief package, which kicked in around the turn of the year and increased many households’ collateral capacity while reducing debt service. SI’s measurement of this component in March will extend over the December-February period, when the debt relief measures were implemented. 

Steep rise in travel component

The travel and transport component of the CPI also weighs heavily in the March increase, according to our forecast. We expect the component to rise by 2.4% (0.35% CPI effect), largely due to fuel prices and airfares. Petrol prices have shot up since SI took the February CPI measurement, and our survey indicates an increase of 4.7% (0.16% CPI effect), the largest MoM rise since February 2013. Our price survey also indicates that airfares rose 10% in March (0.15% CPI effect). In addition, public bus company Strætó raised its bus fares significantly in March, although the increase makes little impact on the CPI. 

Modest end-of-sale effects

Another factor influencing the CPI in March is the end of winter sales (0.2% CPI effect). These end-of- sale effects should be relatively modest, in our opinion, as the exchange rate has been beneficial for purchases of clothing, appliances, and other equipment. Furthermore, the abolition of general excise taxes and the reduction in value-added tax at the turn of the year mitigates the usual end-of-sale increases. 

We do not expect other major subcomponents to make a strong impact on the March CPI. For instance, food prices should change only modestly, unlike the situation in March 2014. In addition, wage settlements are still pending, so wage-related cost pressures are limited, which is also unusual for this time of year. This peaceful interlude may prove a short-lived one, however. 

Moderate near-term inflationary pressures

We expect the CPI to rise by 0.2% in April, 0.2% in May, and 0.3% in June, bringing headline inflation to 1.5% by mid-year. In fact, we expect CPI measurements to yield few surprises in coming months. This assumes, however, that domestic costs will not rise sharply in the wake of upcoming wage settlements and that the recent surge in house prices will ease. We expect house prices to rise 0.5% per month in the near future. In both of these instances, the uncertainty is greater on the upside. On the other hand, we expect imported inflation to be limited, owing to sizeable net foreign exchange inflows and virtually non-existent foreign inflation.

Inflation back above target by year-end

We expect inflation to gain pace steadily as 2015 progresses and rise to 3.0% by the end of the year, surpassing the CBI’s inflation target. Inflation will be higher next year than this year, on average, and we forecast it at 3.0% for the year as a whole. It will be driven primarily by relatively rapid wage increases in the near term, continued rises in real house prices, and elevated imported inflation. It will be modest in historical context, however, and will remain closer to target than it usually has since the adoption of the inflation-targeting regime in 2001. 

The uncertainty in the forecast is concentrated on the upside, however, for two main reasons. First of all, the upcoming wage settlements could generate more rapid rises in nominal wages than we expect, even though the current short-term outlook is for protracted negotiations. Second, we base our forecast on the assumption that the exchange rate will remain close to its current level, as the ISK has been extremely 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 massive foreign exchange outflows, at least temporarily. As regards this latter factor, however, the outlook has improved markedly in the recent term, and the likelihood of a sustained depreciation of the ISK has diminished accordingly.

ISB Research inflation forecast