We forecast a 0.3% rise in the CPI in December

We project that the CPI will rise by 0.3% month-on-month in December. If the forecast materialises, headline inflation will hold unchanged at 2.0% in December, therefore remaining below the Central Bank’s (CBI) 2.5% inflation target.

The short-term inflation outlook has improved somewhat from our last forecast, although the medium-term outlook is broadly unchanged. Inflation appears set to remain low through next spring and then rise over the course of 2016. According to our forecast, it will be close to the inflation target, on average, in 2016 and just below the upper deviation limit in 2017. Statistics Iceland (SI) will publish the CPI for the month at 9:00 hrs. on 22 December.

Steep rise in airfares … for now

The main change from our preliminary forecast lies in a marked upward revision of airfares in the current forecast. We expect a 25% rise in international airfares and project a 23% rise in the air transport component of the CPI (0.29% CPI effect). International airfares have fallen virtually without interruption since July, with the total decline measuring nearly 40%. Furthermore, SI’s December measurement comes at a seasonal peak in air travel, when it is hardly abnormal that prices should spike. We expect this uptick to reverse to a large degree in coming months, however.

The housing component of the CPI will push the index up by 0.09% in December. Our measurement indicates that imputed rent – largely a reflection of developments in house prices – will rise by 0.4% during the month (0.06% CPI effect). Paid rent and other cost items will raise the CPI by 0.03%.

In addition, we expect food and beverage prices to raise the CPI by 0.04% in December, owing mainly to seasonal increases in the price of meat and fruit.

Offsetting this is a 2.3% reduction in clothing and footwear prices (-0.10% CPI effect), resulting mainly from anticipatory price cuts in advance of the cancellation of excise taxes on clothing imported from non-EEA countries. Also affecting our forecast is a 1.9% decline in petrol prices, which we expect to lower the CPI by 0.07% in December. Not only have petrol prices in general fallen at filling stations, but Skeljungur has converted a number of its Orka stations to a new type of filling station, Orkan X, where petrol is sold at lower prices than at the company’s full-service stations, but without requiring a special identity card or key. Presumably, SI will take account of the lower price at these new stations, which differ from the previous budget filling stations requiring prior registration with the fuel company.

Modest inflation in early 2016

We project that the CPI will rise by a total of 0.5% in Q1/2016: a decline of 0.6% in January, followed by a rise of the same amount in February and a 0.5% rise in March.

January is always affected by the tug-of-war between winter sales, which lower the CPI, and annual price list increase, which pull in the opposite direction. We expect seasonal sales to have the upper hand this time, with an overall impact similar to that from last year. In addition, price list increases may prove more modest than usual, not least because utilities prices appear set to rise less strongly than often before. Moreover, we project that the December spike in airfares will more or less reverse in January, and we expect domestic fuel prices to continue falling, in response to the past few weeks’ price drop abroad.

In February and March, end-of-sale effects usually come to the fore, and our forecast takes account of this factor. Furthermore, we expect the housing component to rise steadily, contributing about the same to the CPI as it has in the recent past. According to our forecast, inflation will taper off to about 1.5% by the end of Q1/2016.

Inflation to gain pace further ahead

We expect inflation to pick up somewhat as 2016 passes, rising above the 2.5% inflation target next autumn and measuring 3.5% by the year-end. We expect it measure 3.5% at the end of 2017 as well. The main drivers of rising inflation are strong domestic cost pressures caused by generous wage agreements and the overall heating-up of the economy. Furthermore, the deflation stemming from imported goods will taper off, according to our forecast, as we assume that the exchange rate will hold stable throughout the forecast horizon and that global goods prices will rise marginally.

As usual, the ISK is the main uncertainty in our forecast. For the short term, it appears more likely to strengthen than to weaken, owing to persistent capital inflows in the recent term and the prospect that the settlement of the failed banks’ estates and the release of offshore ISK will not, on the whole, cause substantial foreign currency outflows. Additional appreciation of the ISK could prove to be a double-edged sword, however. In our opinion, a further rise in the real exchange rate will undermine Iceland’s competitive position and exacerbate the risk of a steep drop later on. Moreover, wages could rise faster in the near future than we expect, contributing to higher inflation over the medium term.

Inflation forecast for December