Economic outlook 2016-2018

The GDP growth episode currently underway stands out in many respects from its predecessors. If our forecast materialises, it will be the longest period of continuous positive GDP growth per capita in over 70 years. It will also be the longest period with an external trade surplus over the same length of time and one of the longest periods of price stability. 

We forecast that output growth in Iceland will measure 5.4% this year, the strongest GDP growth rate seen in Iceland in a decade.

We also expect relatively robust GDP growth next year, or 4.0%, making 2017 the third consecutive year with GDP growth in excess of the long-term average and an output gap developing in the domestic economy. 

The output gap will peak next year. We expect the GDP growth rate to ease in 2018, to about 2.6%, as growth in domestic demand and exports subsides. 

If our forecast and the International Monetary Fund’s (IMF) April forecast materialise, Iceland’s 2016-2017 GDP growth rate will be higher than in any other industrialised country. Trading partners’ GDP growth outlook has somewhat deteriorated, while Iceland’s has improved. 

We expect that large pay rises during the year and modest inflation will boost real wages, and we forecast year-2016 real wage growth at 9.1%.

During the next two years, we anticipate smaller wage rises and increased inflation. At the same time, real wage growth will taper off to 4.4% in 2017 and 2.0% in 2018. 

We forecast that unemployment will continue to decline, from 4.0% in 2015 to 3.2% in 2016, followed by 2.8% in 2017 and 2.6% in 2018. 

We project strong private consumption growth this year, or 7.8% in real terms. For the next two years, we expect somewhat slower growth, although it will remain robust, at 5.2% in 2017 and 3.4% in 2018. 

We project that the ratio of investment to GDP will be just over 20% per year during the forecast horizon, with robust investment activity throughout the period. Growth will be strongest by far in 2016, however, and will taper off as the forecast horizon progresses. We project growth at 13.6% in 2016, 6.1% in 2017, and 0.4% in 2018. 

Business investment will be the main driver of investment growth early in the forecast horizon. It, in turn, is driven largely by investment in export sectors such as tourism and silicon product manufacturing, plus investment in production and distribution of electricity. In all, we expect business investment to grow by 17.4% this year and 4.6% in 2017 before falling to 1.8% in 2018.

Public investment has been at a low ebb in recent years. Official estimates provide for continued consolidation, but we expect modest public investment growth in spite of this, given the pent-up need for renewal and further development of infrastructure. We project growth at 2.8% in 2016, 6.3% in 2017, and 4.1% in 2018. 

We expect moderate growth in residential investment, driven by private sector investment and the implementation of the authorities’ plans to invest in rental housing. We project that residential investment will increase by 5.7% this year, 14.3% in 2017, and 8.4% in 2018. 

We expect house prices to increase by 8.1% this year, 8.4% in 2017, and 6.4% in 2018. Rapid growth in real disposable income, households’ improved equity position, limited new construction, rising tourist numbers, and increased importation of labour will push prices upwards. 

Developments in external trade have been extremely favourable in the recent term, and the trade surplus has been sizeable in the past three years. We expect a continued current account surplus throughout the forecast horizon.

Rocket-fire growth in tourism is the main contributor to the hefty current account surplus. Growth in the sector has generated an increasing surplus on services trade. We expect a surplus of ISK 240-250bn this year. 

We estimate real growth in services exports at 14.2% in 2016, 7.0% in 2017, and 4.0% in 2018. 

Goods exports will gather pace over the forecast horizon, owing to increased fishing quotas and the commencement of silicon product exports towards the end of the period. Overall, we project an increase of 0.8% in goods exports this year, followed by just over 3% per year in 2017 and 2018. 

The outlook is for import growth to outpace export growth this year, as import growth usually develops broadly in line with domestic demand growth. We expect import growth to measure 11.2% this year. In the following two years, import growth will subside as domestic demand eases. We project it at 6.5% in 2017 and 3.2% in 2018. On average, import growth will exceed export growth in the latter half of the forecast horizon. 

The outlook is still for a handsome current account surplus in spite of growing demand and a rising real exchange rate. These factors will cut into the surplus, however, as the forecast horizon progresses. We expect the current account surplus to be positive by 4.7% of GDP in 2016, 1.9% of GDP in 2017, and 1.2% of GDP in 2018. 

We anticipate that inflation will remain below the Central Bank’s (CBI) inflation target for a while. The main reason for this is that we expect the króna to appreciate through mid-2017. On the other hand, domestic cost pressures will remain strong and real house prices will keep rising. 

We expect inflation to average 1.8% this year, 2.1% in 2017, and 3.4% in 2018. The turnaround that we expect in the exchange rate in the latter half of the forecast horizon, with currency appreciation giving way to depreciation, will combine with domestic factors to push inflation above the CBI’s inflation target. 

We think it likely that the real exchange rate of the króna will rise in the near future as the output gap widens, as we expect it to do well into next year. This rise in the real exchange rate will probably emerge, at least in part, in a higher nominal exchange rate. 

By the same token, the real exchange rate is likely to fall when GDP growth slows and the output gap begins to narrow. As in the recent past, this will doubtless take place entirely through a nominal depreciation of the króna. 

We expect the nominal exchange rate to rise well into 2017 and then begin to fall again. We project a 6% appreciation this year, followed by an appreciation of 4% over 2017 as a whole and a 5% depreciation in 2018. 

Because of the low inflation provided for in our forecast, the real policy rate will remain high. As a result, the monetary stance will be quite tight over the majority of the forecast horizon, even without further nominal policy rate increases. In view of this and other factors, we expect the effective policy rate to remain unchanged in 2016 and 2017. 

Towards the end of the forecast horizon, in 2018, we expect increased inflation to affect the monetary stance. The CBI’s Monetary Policy Committee (MPC) will probably not respond to the rise in inflation other than to keep the nominal policy rate unchanged, however.