CPI projected to rise 0.3% in May

We expect the consumer price index (CPI) to rise by 0.3% month-on-month in May, thereby remaining unchanged at 1.6%, well below the Central Bank’s (CBI) 2.5% inflation target. In our opinion, the medium-term inflation forecast is broadly unchanged since our last forecast. Inflation looks set to remain below the Central Bank’s (CBI) 2.5% target until near the end of this year. It will be somewhat above the target in 2017 and 2018, however. Statistics Iceland (SI) is scheduled to publish the May CPI at 9:00 hrs. on 27 May. 

Housing, food, hotel accommodation, and petrol prices rise

This time there are four components underlying most of the rise in the CPI, according to our forecast: housing, food and beverages, hotel accommodation, and petrol Of these four, the housing component contributes most to inflation (0.19% CPI effect), as we expect imputed rent to rise by 0.8% month-on-month (0.12% CPI effect), based on our examination of developments in house prices. The small increase in imputed rent in recent months has taken us somewhat by surprise. Apart from this, home maintenance prices have had the strongest impact on the housing component (0.05%), as the recent wage agreements had a considerable effect on this component of the building cost index for May.

We estimate that the rise in food and beverage prices will increase the CPI by 0.05% in May This is due largely to increases in the price of meat and fish (0.03% CPI effect) and fruit (0.02% CPI effect). The peak tourist season is approaching, and we expect accommodation prices to rise by nearly 10% in May (0.04% CPI effect), in line with last year’s developments. Petrol prices have risen by 1.5% (0.05% CPI effect) on average since the SI’s last measurement, in line with rising global market prices.

Of downward-pulling items, the most prominent is international airfares (-0.08% CPI effect), as our survey indicates that prices will fall markedly, as they have in recent years. We expect little change in clothing and footwear prices this month, although they have risen markedly in May in the past few years. It appears that there is still some scope for price reductions in the wake of both the cancellation of import duties on clothing and the appreciation of the króna, as the clothing component had only declined by 3.1% over the twelve months through April. Footwear prices have fallen much more, or by 7.8%. Presumably, the expected reduction in footwear prices has already emerged to a large degree. 

Inflation broadly unchanged in coming months

We forecast a 0.4% rise in the CPI in June, a 0.1% decline in July, and a 0.5% increase in August. According to this, inflation will measure 1.7% at mid-year and bottom out at 1.4% in August. 

As before, the housing component will be the main upward-pulling factor in coming months, with a CPI effect of 0.14% per month, on average. In June, we expect upward pressure from airfares, and hotel and restaurant services. July figures will be affected by seasonal sales, on the one hand, and increased airfares, on the other. The opposite will happen in August, however, with end-of-sales pulling upwards and reduced airfares pulling downwards. 

Rising inflation in H2

We expect inflation to pick up steadily over the second half and rise above the CBI’s 2.5% target at the end of the year. Further ahead, the outlook is for an average inflation rate of 3.2% in 2017 and 3.6% in 2018. The increase in inflationary pressures is due to a rapid rise in domestic wage costs, the sustained rise in real house prices, and the tapering-off of imported deflation, among other factors.

ISK appreciation would reduce 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, it appears more likely to rise than to fall, owing to sustained foreign currency inflows in the recent term, providing enough scope to cover potential outflows in connection with the offshore ISK auction and increased foreign investment by resident entities once the capital controls have been lifted. 

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 1.9% at that time and will be somewhat lower in 2017 as well. As yet, there appears to be some scope for further appreciation of the ISK without jeopardising the external balance of the economy. Ultimately, though, a strong additional appreciation would undermine the competitive position of Iceland’s tradable sector, thereby exacerbating the risk of external imbalances and a currency depreciation. Moreover, wages could rise faster in the near future than we expect, contributing to higher inflation over the medium term.