Our forecast: CPI to rise 0.2% in August

We project that the consumer price index (CPI) will rise by 0.2% month-on-month in August. If our forecast materialises, twelve-month inflation will fall from 1.1% to 0.8% and will therefore breach the 1% lower deviation limit of the Central Bank’s (CBI) inflation target. 

The short-term inflation outlook has improved somewhat since our last forecast. It now appears that inflation will remain below the CBI’s 2.5% target until end-2017. However, it will pick up strongly thereafter and rise above 4.0%, the upper deviation limit, in the latter half of 2018. Statistics Iceland (SI) will publish the CPI for the month at 9:00 hrs. on 26 August. 

End-of-sale effects and house prices push the CPI upwards …

End-of-sale effects always affect the August CPI measurement, and we expect them to do so this month as well. On the whole, however, we expect the goods that dominate summer sales to fall in price during the third quarter, when the effects of seasonal sales have reversed, as these goods are  generally imports. We expect clothing and footwear prices to rise by 5.0% (0.19% CPI effect). Overall, we expect end-of-sale effects to push the CPI upwards by 0.25% in August. 

The housing component will be the second-largest contributor to this month’s rise in the CPI (0.16% CPI effect). This is due mostly to a 1.0% rise in imputed rent (0.15% CPI effect), as our survey indicates that house prices will weigh heavily in this month’s measurement. And finally, the outlook is for the price of restaurant services to raise the CPI by 0.04%, as the tourist season is at its peak and wage-related cost pressures are significant in the sector. Furthermore, the education component will push upwards, as it usually does in August. We estimate this month’s CPI effect at 0.03%, owing mainly to a hike in fees at Reykjavík University. 

Offsetting these upward-pushing items are the direct and indirect effects of the appreciation of the ISK, which pull strongly downwards in August. These effects show most prominently in the travel and transport component of the index (-0.34% CPI effect), where seasonal factors and price developments abroad pull in the same direction. Several factors are at work here: petrol prices are down 4.8% (-0.18% CPI effect) and airfares have fallen markedly (-0.13% CPI effect), as have motor vehicle prices (-0.07% CPI effect). A variety of other import subcomponents fall as well in our forecast, offsetting the rise in various domestic services and manufactured goods prices. A good example of this is the food component, where rising prices of domestic products such as meat, fish, and vegetables and falling prices of imported foods pull in opposite directions. Therefore, on the whole, the food and beverage component will raise the CPI by only 0.02% this month. 

Inflation moderate in coming months

The outlook is for modest inflation in the next few months, not least because of the continued impact of the ISK appreciation. We forecast no change in the CPI in September, a 0.1% rise in October, and a 0.1% drop in November. If these projections materialise, headline inflation will measure 1.5% in November. 
As before, the housing component will be the main upward-pulling factor in coming months, with a CPI effect of just over 0.12% per month, on average. In September, education, recreation and entertainment, and end-of-sale effects will push the index upwards, and in addition, we expect the housing component to rise, although airfares will pull downwards. In October, the housing component will be the main driver, while in November we expect reduced airfares and food prices to outweigh the rise in house prices. 

Inflation below target through end-2017

The outlook is for domestic inflation to remain moderate, as long as the ISK does not give way. We expect it to average 1.6% in 2017 and to measure 2.2% by the end of that year. We anticipate a rapid rise thereafter, however, with headline inflation overtaking the 2.5% inflation target at the beginning of 2018 and rising above the 4.0% upper deviation limit in the third quarter of the year. Inflation last broke the 4.0% barrier at the end of 2013. 

The ISK exchange rate is the main determinant of the medium-term inflation developments in this forecast. We assume that the ISK will continue to strengthen until Q3/2017, by roughly 5% from the current level. We then expect it to weaken again thereafter, as the real exchange rate will be quite high, GDP growth will start to ease and the output gap to narrow, and trade-related foreign currency inflows will begin to abate. A weaker currency will usher in higher inflation, although the outlook for more moderate rises in wage costs and house prices in the latter half of the forecast horizon will soften the impact.

Inflation forecast for August 2016