Preparing to land: Macroeconomic forecast 2017-2019
The past few years have seen a strong upswing following the recession at the beginning of the decade. We believe that the upward cycle topped out last year, when output growth measured 7.4%. The outlook is for growth to remain robust this year and then ease steadily. We project it at 4.5% in 2017, 2.8% in 2018, and 2.3% in 2019.
Households appear to be the main driver of growth during the forecast horizon, with private consumption and residential investment supplanting services exports and business investment, although services exports will continue to grow strongly in coming years.
Although output growth will be somewhat weaker than in the recent past, it bears the characteristics of a rebalancing rather than a setback. It is quite likely that Iceland will experience the oft-cited yet ever-elusive soft landing after the current upswing.
Current account surplus shrinks
Growth in services exports – tourism in particular – has been one of the main features of export growth in recent years. Services exports accounted for more than 4/5 of last year’s nearly 11% growth in total exports, for instance. The outlook is for tourism to continue to be the mainstay of export growth, even though the pace of growth in the sector will ease over the forecast horizon. We also expect moderate growth in goods exports in the next few years. Growth in both imports and exports is projected to ease as the forecast horizon progresses. Import growth will outpace export growth throughout the period, however, and the contribution of net trade to output growth will therefore be negative.
The current account surplus has been quite large in the past four years. It is projected to shrink over the course of the forecast horizon, as the surplus on goods and services trade narrows, yet we expect the current account balance to remain positive, at a scant 5% of GDP this year, just under 4% in 2016, and slightly above 3% in 2019.
Households to take the lead in GDP growth
Investment has grown strongly in recent years, private investment in particular. Last year was the first year since the onset of the crisis in 2008 to see an investment-to-GDP ratio exceeding 20%. The investment ratio is expected to remain above 1/5 of GDP throughout the forecast horizon. The share of residential investment in total investment will increase, however, and the share of business investment will decline accordingly.
Demand pressures in the labour market have grown steadily in the recent term. Unemployment is now close to an all-time low, and the labour participation rate is near its historical peak. We project unemployment at 2.7% of the labour force this year, 2.8% next year, and 2.9% in 2019.
Since the beginning of 2012, real wages have grown by an average of 4.7% per year. Real wage growth peaked in 2016, at 9.5%. The outlook is for slower wage rises during the forecast horizon, however, and a much smaller rise in real wages. That said, our forecast indicates that real wage growth will average a full 3% per year, a robust growth rate both historically and in international context.
Private consumption growth has been gaining momentum in the recent term, supported by strong real wage growth, households’ improved financial position, a rising labour participation rate, and population growth, among other factors.
We project private consumption growth at 8.0% this year, 5% in 2017, and 3% in 2019. in the latter two years, it will be in line with combined growth in real wages and population.
Modest changes in exchange rate, inflation, and policy rate
We expect the exchange rate to hold broadly steady during the forecast horizon, at the average for 2017 to date. The current account surplus is shrinking, the interest rate differential with abroad has narrowed, and investment flows have normalised somewhat in comparison with the recent past. The outlook is for a relatively strong ISK over the forecast horizon; however, this assumption is highly uncertain, given the extremely short time since the capital controls were liberalised.
We expect inflation to rise slightly over the coming winter but to settle temporarily at just above the 2.5% target next spring. We project that it will average 3.0% in 2018 and 2.8% in 2019.
Stable inflation and moderate inflation expectations have enabled the Central Bank (CBI) to lower the policy rate in spite of the economic upswing. The rate cut in the first half of 2017 appears to have been intended to hold the real policy rate close to its early-2017 level.
However, rising inflation will push the real policy rate upwards in coming quarters, other things being equal, and we expect the CBI to hold the effective policy rate unchanged in the near term, so as not to accelerate the decline in the real rate. There could be scope for further nominal rate cuts in the latter half of the forecast horizon, however.