Iceland Central Bank Statement

Author: | Published: 19 Oct 2018
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

The current economic situation in Iceland is characterised by a slowdown in growth from an unsustainably high level and subsiding overheating risks.

The economy grew by 7.5% in 2016 but was probably already at full employment in 2015. Nevertheless, inflation remained below the agreed 2½% target from early 2014 until very recently. This was in spite of nominal wages increasing by an average of 8.5% p.a. during 2015-2017. This constellation of economic outcomes stems from strong export growth (due mainly to tourism), improvements in terms of trade, record importation of labour, imported goods deflation and prudent macroeconomic policies. These developments contributed to a higher equilibrium exchange rate and mitigated the resource constraints of the economy, which in turn made it possible for the economy both to grow so rapidly and to accommodate large wage increases while inflation remained close to but below target.

The strong real appreciation of the currency in 2015-2017 (more than 30%), a key part of the adjustment process, was broadly consistent with the rise in the real equilibrium exchange rate. Iceland has had a current account surplus since 2009. The surplus peaked at almost 8% of GDP in 2016 but has since fallen to the 1-2% range. Furthermore, Iceland recorded a positive net international investment position of 7% of GDP at the end of 2017, compared to a negative net international investment position of 130% just after the financial crisis. In light of slower export growth and a shrinking current account surplus, a significant further real appreciation would entail risks.

The economic conditions that underpinned the non-inflationary boom of recent years are changing. According to the Central Bank of Iceland's May 2018 forecast, export growth is slowing down and the improvement in terms of trade has stalled. Economic growth is rapidly approaching a more sustainable level of around 3%. The positive output gap has narrowed significantly from its peak in 2016 and is set to shrink further. Furthermore, house price increases, which were very strong during the recent boom years, have now slowed significantly. The risk of overheating has therefore subsided. At the same time, the improvement in economic conditions that allowed strong non-inflationary real wage growth is unlikely to be repeated in coming years. As a result, more moderate wage growth will be required in order to keep inflation at target. The current strife in the labour market is therefore a medium-term risk factor for inflation in Iceland.

Monetary policy has been relatively tight in recent years, with the real policy rate being in the 2.5-3% range in 2016 and until the third quarter of 2017. This might seem surprising given that until recently, inflation had been below target for around four years. However, demand pressures and the risk of overheating called for a tight stance. Furthermore, longer-term inflation expectations were well above target until late 2016. Bringing long-term inflation expectations to target is one of Iceland's main monetary policy achievements in the recent term and allowed the real policy rate to fall to around 1.5% more recently. It also increases the scope of monetary policy to mitigate negative shocks to growth in the future.

 


 

 

close Register today to read IFLR's global coverage

Get unlimited access to IFLR.com for 7 days*, including the latest regulatory developments in the global financial sector, updated daily.

  • Deal Analysis
  • Expert Opinion
  • Best Practice

register

*all IFLR's global coverage published in the last 3 months.

Read IFLR's global coverage whenever and wherever you want for 7 days with IFLR mobile app for iPad and iPhone

"The format of the Review has changed over the years; the high quality of its substantive content has not."
Lee C Buchheit, Cleary Gottlieb

register