CPI to rise 0.5% in February

We project that the consumer price index (CPI) will rise by 0.5% month-on-month in February. If our forecast materialises, this will be the smallest February rise in the CPI since 2009, lowering headline inflation from 2.1% to 2.0% and extending the streak of below-target inflation. 

In our opinion, the medium-term inflation outlook has improved somewhat since our last forecast. Inflation looks set to remain below the Central Bank’s (CBI) 2.5% target until the fourth quarter of this year. It will rise above the target by the year-end, however, and remain somewhat above it in 2017 and 2018. Statistics Iceland (SI) is scheduled to publish the February CPI at 9:00 hrs. on 25 February. 

End-of-sale effects push the CPI upwards

As is usually the case in February, the end of seasonal sales generates the main upward pressure on the CPI at present. Winter sales on goods such as furniture and electronic equipment were unusually deep in January, but we do not expect end-of-sale effects to be equally abrupt, as we think it likely that retailers have purchased new inventory at a much more favourable exchange rate than was prevailing when the sale goods were bought. Clothing and footwear prices benefit as well from the cancellation of the 15% excise tax, which (other things being equal) should lower the prices merchants must pay to bring in new goods.

End-of-sale effects are strongest for clothing and footwear (0.18% CPI effect), furniture and housewares (0.10%), and electronic equipment (0.09%). Overall, the end of seasonal sales will raise the CPI by about 0.4% in February. 

Among other upward-pushing items, the housing component is strongest this time (0.10% CPI effect). Of that amount, we expect imputed rent to raise the index by 0.08% and paid rent to raise it by 0.03%. The home maintenance portion of the housing component will decline slightly in February, however. 
Downward pressure on the CPI comes mainly from a 2% drop in petrol prices (-0.06% CPI effect) and a nearly 0.3% decline in food and beverage prices (-0.04% CPI effect), the latter due mainly to a reduction in the price of fruit. 

The effect of international airfares on the CPI is uncertain at present, as our January measurement indicated an entirely different result (-16%) than SI’s measurement (+3%). Our measurement for February implies that prices will rise somewhat between months, but it should be noted that airfares fell in February 2015. As a result, we have decided to keep this item unchanged in our forecast. 

Modest inflation through the autumn

The outlook is for the CPI to rise much less in H1/2016 than we assumed in our last forecast. We expect it to rise by 0.5% in March, 0.2% in April, and 0.2% in May, and by a total of 1.2% over the first half of the year. If this forecast materialises, inflation will bottom out at 1.4% in May and will average 1.7% over the first six months of the year. 

As usual, end-of-sale effects will push the CPI upwards in March, but less than often before, owing to the aforementioned cancellation of excise taxes on clothing and footwear. We also expect the housing component to rise steadily, contributing about the same to the CPI as it has in the recent past. In other respects, the outlook is for a relatively modest increase in goods and services prices in coming months. 

Inflation to gather pace further ahead

We expect inflation to pick up in the second half, rise above the CBI’s 2.5% target in the fourth quarter, and measure 3.0% at the year-end. Further ahead, the outlook is an average inflation rate of 3.4% in 2017 and 3.5% in 2018. The increase in inflationary pressures is due to the continued rapid rise in domestic wage costs, ongoing rise in real house prices, and the tapering-off of imported deflation, among other factors.

ISK appreciation would contain inflation

As usual, the ISK is the major uncertainty in our forecast. We expect the exchange rate to remain unchanged in the coming term. In the short run, however, the ISK appears more likely to appreciate than to depreciate, owing to sustained foreign currency inflows in the recent term, providing enough scope to cover potential outflows in connection with the offshore ISK auction, pension funds’ increased authorisations for foreign investment, and the settlement of the failed banks’ estates. 

Further appreciation would cause inflation to be lower than we have projected here; for instance, our forecasting model indicates that if the ISK strengthens by 5% from now until the year-end, headline inflation will measure 2.2% at that time and will be somewhat lower in 2017 as well. 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 ultimately 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.