CPI to rise 0.6% in March

We project that the consumer price index (CPI) will rise by 0.6% month-on-month in March, lowering headline inflation from 2.2% to 1.7%, as the CPI rose a full 1.0% in March 2015. If our forecast materialises, the streak of below-target inflation will be extended by another month. 

In our opinion, the medium-term inflation outlook has deteriorated slightly 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) will publish the March CPI at 9:00 hrs. on 30 March. 

Housing, end-of-sale effects, and travel push upwards 

The housing component is the strongest driver of this month’s rise in the CPI. We expect the housing component as a whole to rise by 0.6% (0.18% CPI effect). The most important contributor here is imputed rent, where we project an increase of 1.0% (0.16% CPI effect), as our survey indicates that the rise in housing market prices will weigh heavily in the CPI measurement. 

We expect clothing and footwear prices to rise 3.7% during the month (0.15% CPI effect), as winter sales are now over. The upward impact from this component is much smaller now than in our forecast from a year ago, for three reasons. First of all, end-of-sale effects were stronger in February than we had anticipated. Second, the cancellation of excise tax on the majority of imported clothing and footwear articles will probably finally kick in now that seasonal sales are over. And third, new goods being sold in clothing and shoe stores were probably bought at a more favourable exchange rate than those offered during the winter sales. At all events, we would think it quite odd if the appreciation of the króna and the excise tax cancellation did not cause a marked drop in consumer prices of clothing and footwear. On the whole, we expect milder end-of-sale effects than usual this year; in particular, we do not envision a large increase in the price of housewares and electronic equipment after the steep rises in February. 

We project that the travel and transport component will raise the CPI by 0.14% this month. This is due mainly to a nearly 7% rise in air transport prices (0.09%), as there are signs of a significant increase in international airfares. Furthermore, petrol prices have risen by an average of 1.5% since the February CPI measurement, in tandem with price hikes abroad (0.05% CPI effect). 

We do not see scope for many downward-pulling items this month, although a minor drop in food/beverages and in alcohol/tobacco would not come as a surprise (-0.01% CPI effect combined). Other items carry less weight but have a combined upward effect of 0.09% in March. 

Modest inflation through the autumn

The outlook is for the CPI to increase by a total of 1.4% in the first half of the year. We expect it to rise by 0.2% in April, 0.2% in May, and 0.3% in June, making for a headline inflation rate averaging 1.9% over the first half of 2016. 

The housing component will weigh heaviest among upward-pushing items in coming months. We project it to rise by 0.7% per month, as it has done, on average, over the past twelve months. According to our forecast, airfares will climb somewhat in April, fall again in May, and then rise steeply in June, in line with the seasonal pattern seen in recent years. The rise in hospitality service prices – hotels and restaurants – will weigh heavily in the increase in the CPI in May and June, when the peak tourist season gets underway. 

Rising inflation in H2

We expect inflation to pick up steadily over the second half of the year, rise above the CBI’s 2.5% target in the fourth quarter, and measure 3.2% at the year-end. Further ahead, the outlook is an average inflation rate of 3.4% in 2017 and 3.3% in 2018. The increase in inflationary pressures is due to the continued surge in domestic wage costs, the sustained rise in real house prices, and the tapering-off of imported deflation, among other factors. 

ISK appreciation will 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 2.5% at that time and will be somewhat lower in 2017 as well. Additional appreciation of the ISK could prove to be a mixed blessing, however. In our opinion, a further rise in the real exchange rate will ultimately erode the competitive position of Iceland’s tradable sector and exacerbate the risk of mounting external imbalances and a steep currency depreciation later on. Moreover, wages could rise faster in the near future than we expect, contributing to higher inflation over the medium term.