CPI to rise 0.5% in December

We project that the consumer price index (CPI) will rise by 0.5% month-on-month in December, raising twelve-month inflation from 2.1% to 2.3% if our forecast materialises. This would be the highest inflation rate since mid-2014. 

However, the medium-term inflation outlook has improved somewhat since our last forecast. We have made major changes to the assumptions underlying the forecast, as the ISK is stronger than in the previous forecast, while the projected rise in wage costs and house prices is steeper. We expect inflation to decline in the near term, measuring below 2.0% for nearly all of 2017. We project that it will pick up rather strongly 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. Statistics Iceland (SI) will publish the CPI for the month at 9:00 hrs. on 22 December. 

Airfares and housing by far the strongest upward-pushing items

The housing component of the CPI has been the strongest upward-pushing component of the index in recent months, and we expect it to remain so this time. Our survey indicates that imputed rent – largely a reflection of developments in house prices – will rise by 1.3% during the month (0.21% CPI effect). The housing component as a whole will push the index up by 0.23% in December. In addition to imputed rent, paid rent and electricity costs will rise, according to our forecast, while home maintenance costs will fall. 


However, we project that air transport will be the strongest driver of the rise in the CPI this month (0.33% CPI effect). The main determinant here is international airfares, as our survey suggests an unusually strong uptick this month, although we expect domestic airfares to rise as well. We expect international airfares to take a nosedive after the turn of the year, however, so that the inflationary impact should be temporary. 
Other components that appear likely to rise will have a lesser impact on the CPI this month, including telephone and internet costs (0.02% CPI effect), furniture and housewares (0.01%), hotel and restaurant services (0.01%), and other goods and services (0.02%). 

Food, clothing, and other items 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 16% in trade-weighted terms since mid-year. 

For example, in our December forecast the currency appreciation is the main driver of declines in the price of food and beverages (-0.04% CPI effect), clothing and footwear (-0.03%), new motor vehicles (-0.03%), pharmaceuticals and medical products (-0.02%), and alcohol and tobacco (-0.01%). The combined impact from other items was negligible in December.

Inflation to fall again in coming months

The outlook is for inflation to ease again in the first quarter of 2017. We project that the CPI will fall by 0.8% in January and then rise by 0.5% and 0.4%, respectively, in February and March. According to these projections, inflation will measure 1.9% in March 2017. 

On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.16% per month. In January, strong seasonal sale effects will make their mark, 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, although increases in the price of other utilities and housing-related services will have an offsetting effect. In addition, we expect airfares to fall markedly in January and February, after the surge in December. Price list increases, which often affect the CPI in January, look set to have a modest impact this time round, and seasonal sale effects will largely reverse in February and March. 

Inflation below target throughout 2017

The outlook is for domestic inflation to remain moderate, as long as the ISK does not lose ground. We expect inflation to average 1.6% in 2017 and to measure 1.3% by the end of that year. We project that it will 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. 

We have changed a number of the assumptions underlying our long-term forecast, based on recent developments and the most recent indicators of near-term developments. We now assume that the ISK will continue to strengthen through Q3/2017, by roughly 10% from the current level. This is much larger appreciation than in our previous forecasts. It is due in part to a more favourable current account balance than previously anticipated, a marked improvement in Iceland’s external position, and stronger-than-expected GDP growth. We then expect the ISK 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 bring 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. The exchange rate path is therefore higher throughout the forecast horizon than in our previous forecasts. 

On the other hand, there is more uncertainty than before about wage developments ahead, given the growing unrest in the labour market and the municipalities’ recent wage settlements with primary school teachers, which may well set the tone for other groups’ wage demands in the quarters to come. As a result, we have increased the assumed wage level in our inflation forecast. We now expect wages to rise by 6.8% over 2017 and about 5.2% in 2018. We have also adjusted our house price projections upwards, in view of the rapid rise in the recent term and indications of continued inflationary pressures in the residential housing market. We now expect house prices to rise 10.3% next year and 6.3% in 2018. 

The overall impact of these changed assumptions is to lower our inflation projections for 2017, while the forecast for 2018 is broadly unchanged.