CPI projected to rise 0.1% in October

We project that the consumer price index (CPI) will rise by 0.1% month-on-month in October, raising twelve-month inflation from 1.8% to 1.9% if our forecast materialises.
The medium-term inflation outlook is broadly unchanged since our last forecast, although short-term inflation is now higher than before because of Statistics Iceland’s (SI) correction of errors it made earlier in the year. As before, it appears that inflation will remain below the CBI’s 2.5% target until end-2017. However, it will rise briskly thereafter and hover around 4.0%, the upper deviation threshold, in the latter half of 2018. SI is scheduled to publish the October CPI at 9:00 hrs. on 27 October.

Housing and airfares pull upwards

Of the main drivers of inflation, airfares are among the most prominent at present, after a steep decline in September. We expect the air transport component to raise the CPI by 0.12% this month, mainly due to rising international airfares. However, we think this will only be a temporary spike that could reverse in the months to come. 

Apart from airfares, the housing component is the main upward-pushing component (0.09% CPI effect). The CPI effect this month should be less pronounced than often before, however, owing both to a more modest rise in imputed rent, according to our survey (0.08% CPI effect), and a month-on-month decline in maintenance costs (-0.01% CPI effect).
Petrol prices in Iceland have risen slightly in recent weeks, on the heels of a rise in global prices, and we expect a CPI effect of 0.02% as a result. And finally, the hike in food costs in Reykjavík primary schools has an upward impact in our forecast.

Clothing, motor vehicles, food, and pharmaceuticals pull downwards

Offsetting the above-mentioned upward effects are reductions in various CPI subcomponents in which the appreciation of the ISK plays a major role, as the currency has strengthened by about 9% in trade-weighted terms since mid-year. The drop in clothing and footwear prices weigh heavily here (-0.06% CPI effect), as there are signs that clothing prices are falling, including the Lindex chain’s announcement of an average price cut of 8% in its stores.
Other factors include reduced prices of motor vehicles (-0.03% CPI effect), food and beverages (-0.04% CPI effect), and pharmaceuticals (-0.01% CPI effect). Motor vehicle prices have fallen by 4% and drug prices by nearly 8% in the past year, mainly because the appreciation of the ISK has lowered import prices. In addition, we expect price cuts for a variety of other imports, although the overall impact there will be less pronounced. Finally, the seasonal reduction in accommodation prices will pull the CPI downwards by 0.02%, according to our forecast.

Inflation broadly unchanged in coming months

The CPI looks set to rise relatively little from now until the year-end, owing mainly to the strengthening of the ISK, which we hope will continue, although the pace of the appreciation will probably ease as winter approaches. We forecast that the CPI will fall by 0.2% in November, then rise by 0.3% in December, and fall again, by 0.7%, in January. According to these projections, inflation will measure 2.0% at the end of the year. 

On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.13% per month. We expect airfares and various imported items to decline in November. In December, however, airfares will push strongly upwards, in keeping with the usual seasonal pattern. In January, strong seasonal sale effects will kick in, as will the planned cancellation of customs duties on various imported goods and the expected reduction in utility company OR’s fees for electricity transmission and cold water. 

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 inflation to average 1.7% in 2017 and to measure 1.9% by the end of that year. We expect it to pick up thereafter, overtaking the Central Bank’s (CBI) 2.5% inflation target in Q2/2018 and hovering near 4.0%, the upper deviation threshold of the target, in the fourth quarter of the year. 

The ISK exchange rate is the main determinant of the medium-term inflation developments provided for in this forecast. We assume that the ISK will continue to strengthen through Q3/2017, by slightly more than 4% 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. 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 cushion the impact. On the other hand, uncertainty about wage developments is greater than before because the so-called SALEK agreement, which was supposed to contribute to stability and harmonisation in the labour market, now appears to be up in the air.