We forecast a 0.4% rise in the CPI in May

We project that the consumer price index (CPI) will rise by 0.4% month-on-month in May, leaving headline inflation unchanged at 1.9%. 

In our opinion, the medium-term inflation outlook is broadly unchanged since our last forecast. That said, we project that headline inflation will be below the Central Bank’s (CBI) 2.5% inflation forecast throughout 2017, measuring 2.2% at the year-end. We then expect it to pick up once more, overtaking the target in Q1/2018 and averaging 3.3% in the latter half of the forecast horizon. 

Housing, food, and accommodation push upwards

As in the recent past, the rise in the CPI is driven mainly by the housing component. The real estate market has been buoyant recently, and our survey indicates that imputed rent, which is mainly a reflection of developments in house prices, will rise by 2.0% this month (0.35% CPI effect). Other upward-pushing items include hotel and restaurant services, which are closing in on the peak tourist season (0.06% CPI effect) and food and beverages, as we expect an uptick in the price of meat, bread, and fruit (0.10% CPI effect). Domestic wage costs will make their mark on domestic food production this month, in our estimation, and could also affect prices in June, as several producers have announced price hikes following the pay increases taking effect in May.

Airfares, petrol, clothing, and housewares push downwards

Offsetting these upward-pushing items are several that will pull in the opposite direction. Chief among them are airfares, which our price survey indicates will lower the CPI by 0.09% in May. Furthermore, petrol prices have fallen somewhat, in response to a steep drop in global prices (-0.06% CPI effect). We also expect a decline in clothing and footwear prices (-0.02% CPI effect), as well as furniture and housewares (-0.01%), due to growing competition and the appreciation of the ISK. Other components will make less of an impact, raising the index by a total of 0.05% in May. 

Inflation broadly unchanged in the near term

The outlook is for a slight acceleration in inflation over the next few months. We forecast a 0.3% rise in the CPI in June, a 0.2% decline in July, and a 0.4% increase in August, leaving headline inflation at 2.2% in August. 
On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.22% per month. The impact of the swift rise in house prices on the CPI is even stronger than it would be otherwise, as Statistics Iceland increased the weight of imputed rent in the calculation of the index this past spring, in line with its established calculation method. We also expect a seasonal rise in airfares in June and July, followed by a decline in August. Furthermore, seasonal sales will affect the CPI in July, as usual, as will end-of-sale effects in August. 

Inflation below target through end-2017

The outlook is for domestic inflation to remain moderate over the forecast horizon, as long as the ISK does not weaken. We expect inflation to hold broadly unchanged through most of this year, remaining below target and measuring 2.2% in December. We expect the pace to pick up as the winter advances, however. We project that inflation will overtake the 2.5% target in Q1/2018 and remain slightly above the target over that year. We expect it to average 2.8% in 2018 and 3.3% in 2019. 

Key determinants in the coming term

As usual, the ISK exchange rate is the main determinant in our forecast, and as before, we expect it to rise until the last quarter of this year. We expect an appreciation of approximately 4% over the period. As we have done previously, we assume that the exchange rate will fall gradually over the latter part of the forecast horizon, as the trade surplus narrows and the high real exchange rate makes its presence felt. 

Wage hikes will continue to put upward pressure on domestic prices, as we assume that wages will rise somewhat more than is consistent with the inflation target plus productivity growth. That pressure will gradually ease over time, however, as tension in the labour market subsides. Developments in the labour market are highly uncertain in the latter half of the forecast horizon, however, as a large number of public sector wage agreements will expire in the second half of 2017. This could also affect private sector wage settlement reviews after the turn of the year. 

We expect house prices to keep rising fairly rapidly in coming months, as they have in the recent past. They will continue rising thereafter, according to our forecast, albeit at a gradually reduced pace.