Macroeconomic forecast - September 2016

Macroeconomic Forecast September 2016 – Summary

  • We forecast relatively robust GDP growth for Iceland in 2016 and 2017, or 4.9% and 5.1%, respectively – a stronger growth rate than has been measured in Iceland since 2007. We then expect growth to taper off to 3.0% in 2018. 
  • The GDP growth outlook for the forecast horizon has improved overall since our last forecast, published at the beginning of June. We expect growth to be 1.1 percentage points stronger in 2017 and 0.4 percentage points stronger in 2018 than in our previous forecast, but we have reduced our GDP growth forecast for 2016 by 0.5 percentage points.
  • Iceland’s GDP per capita has increased considerably in recent years and is now relatively high in international context. After adjusting for purchasing power, in 2015 it was at its pre-crisis high of 24% above the EU average. It can be assumed that Iceland will gain even further ground in this context both this year and next year, in part due to Iceland’s strong GDP growth in international comparison. 
  • Important factors in households’ position have developed favourably in the recent term, supporting rapid growth in private consumption. First of all, real wages have seldom risen as strongly as they are currently doing, far outpacing real wage growth during the last upswing. Jobs have also increased rather rapidly and unemployment has fallen. We therefore project private consumption to grow by 8.1% in real terms this year. If our forecast materialises, this will be the strongest private consumption growth seen in Iceland since 2005. 
  • We expect private consumption growth to subside over the next two years, which is a normal development, and fall to 5.5% in 2017 and 3.4% in 2018, which is still relatively strong. This is based in part on our forecast of real wage growth, which we estimate at 10.0% this year, 5.2% in 2017, and 2.3% in 2018. 
  • Unemployment has declined concurrent with growing economic activity. An increased part of the labour needs of GDP growth is now met with imported labour, which explains the relatively rapid growth in population at present. We forecast that unemployment will continue to decline, from 4.0% in 2015 to 3.1% this year, followed by 2.7% in 2017 and 2.5% in 2018. During the forecast horizon, unemployment will remain below the equilibrium unemployment rate, and the marked tension in the labour market will persist. 
  • Investment has grown strongly in the recent past and is now at a level that is considered appropriate for an advanced economy. We expect it to rise by 21.3% year-on-year in 2016 and then by 7.2% and 0.6%, respectively, in 2017 and 2018. 
  • The recent pick-up in investment is driven largely by rapid growth in business investment, a large portion of it directly or indirectly related to tourism. We expect business investment to grow by 25.6% YoY in 2016 and 5.9% in 2017, and then to contract by 1.6% in 2018. The downturn in 2018 is due primarily to a YoY decline in investment in ships and aircraft and construction equipment. 
  • We expect house prices to increase by 8.5% this year, 9.7% in 2017, and 6.6% in 2018. Rising real disposable income, together with demographic factors, rapid growth in tourism, and limited new residential construction will push prices upwards. Real house prices will rise by 6.9% this year, 8.0% in 2017, and 3.4% in 2018. 
  • We project that residential investment will increase by 17.7% this year, 16.0% in 2017, and 8.5% in 2018. The current population surge, driven partly by significant importation of labour, calls for increased investment in residential property. Furthermore, a portion of residential property has been used to house foreign tourists, in response to the rapid growth in tourism, which appears likely to continue. 
  • Since 2013, the current account surplus has been sizeable and has played a leading role in both improving Iceland’s external position and strengthening the Central Bank’s (CBI) foreign exchange reserves. This handsome current account surplus is due mainly to the exponential growth of the tourism industry, which generated 35% of total export revenues in the first half of 2016. 
  • We expect services exports to grow at five times the rate of goods exports during the period. Service exports will grow most this year, or about 14.4%, according to our forecast. For 2017, we project 12% growth, and for 2018 we expect 7%. 
  • Marine product exports will pick up during the forecast horizon. We forecast an increase of just over 4% in 2017, followed by just over 3% in 2018. On the other hand, exports of energy-intensive industrial products will grow rather weakly during the forecast horizon, owing to delays and uncertainties relating to development in the sector. 
  • Imports have grown rapidly in the recent term, in tandem with growth in domestic demand and services exports. We anticipate that import growth will ease as the forecast horizon progresses and investment, private consumption, and services exports taper off. We project that imports of goods and services will grow by 1.2% in 2016, 7.7% in 2017, and 4.0% in 2018 and that imports and exports will be more or less in balance during the latter two years. 
  • We expect a surplus on the current account for the entire forecast horizon. We forecast that it will measure 4.2% of GDP this year and 1.6% and 1.5%, respectively, in 2017 and 2018. If this forecast materialises, the accumulated current account surplus for the period 2013-2018 will amount to one-fourth of GDP.
  • The ISK has appreciated markedly in trade-weighted terms in the recent past – by 11% year-to-date and 20% over the past two years. We assume that it will continue to strengthen until H2/2017, by roughly 5% from the current level. We then expect it to weaken again, as the real exchange rate will be quite high, GDP growth and demand pressures will start to ease, and trade-related foreign currency inflows will begin to abate, cutting into the current account surplus. 
  • When capital controls on residents have been lifted, the foreign exchange market landscape will change, ushering in greater uncertainty about the exchange rate than has prevailed in recent years. Liberalisation of the controls could trigger capital outflows and put downward pressure on the exchange rate, at least temporarily, owing to increased outward foreign direct investment and portfolio rebalancing by firms and individuals seeking to diversify risk. On the other hand, the spread between domestic and foreign interest rates is wide, GDP growth is stronger in Iceland than in trading partner countries, Iceland’s net external debt position is favourable, terms of trade have improved, and there are strong foreign currency inflows as a result of the vibrant tourism sector. 
  • The recent appreciation of the ISK has reflected in part the adjustment of the real exchange rate to a higher equilibrium. The real exchange rate is now just above the CBI’s estimate of the equilibrium real exchange rate. Given that the current upswing has not yet topped out and will not do so until next year, according to our forecast, there is good reason to believe that the real exchange rate will continue to rise. We consider it likely that this rise will be due in large part to a nominal appreciation of the ISK. By the same token, when the output gap begins to narrow, the real exchange rate is likely to fall, entirely as a result of a nominal depreciation. 
  • In spite of strong domestic inflationary pressures, inflation has now been below the CBI’s target for two-and-a-half years, mainly because of imported deflation. 
  • We expect inflation to average 1.6% in 2017 and to measure 2.1% by the end of that year. We then expect it to begin rising and to average 3.1% in 2018. 
  • We are of the opinion that the CBI’s Monetary Policy Committee (MPC) will lower the CBI’s key interest rate by another 0.5 percentage points this calendar year. The MPC’s next interest rate decision date is 5 October, and we expect a 0.25-point rate cut that day. The ISK exchange rate has risen since the last interest rate decision and inflation expectations have fallen still further, and we expect the MPC to mention this in its decision to lower interest rates. We forecast another 0.25-point rate cut in November of this year. After that, we expect the CBI’s policy rate to remain unchanged throughout the forecast horizon. The real policy rate will begin to taper off, however, as 2017 progresses and inflation starts to pick up.

Forecast summary