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Icelandic Financial Market Digest 27. janúar

Publisher: Íslandsbanki Research • Resp.Editor: Ingólfur Bender

Inflation holds steady at 1.9% in January

According to newly published figures from Statistics Iceland (SI), inflation remained unchanged month-on-month in January, at 1.9%. It has now been below the Central Bank’s (CBI) 2.5% inflation target for three years running and looks set to remain there for a while to come. The recent low-inflation episode is due almost entirely to the appreciation of the ISK, and it is indeed the ISK that will determine, for the most part, whether inflation remains modest or rises in coming quarters. 

The consumer price index (CPI) fell by 0.57% month-on-month in January, in line with our expectations. Official forecasts provided for a decline in the 0.5-0.6% range. Because this month’s drop in the CPI was similar to that from a year ago, twelve-month inflation is unchanged at 1.9%. The CPI excluding housing fell by 0.20%, however, and twelve-month inflation thus measured is negative by 0.9%. In other words, the inflationary impact of housing far exceeds inflation itself, and the differential between inflation according to the CPI and inflation according to the CPI excluding housing has broadened significantly. 

Seasonal sales and ISK appreciation the main downward influences

As we had expected, seasonal sales had a strong downward impact on the CPI in January. For example, clothing and footwear prices fell by 10.0% (-0.42% CPI effect), furniture and housewares by 10.3% (-0.15% CPI effect), electrical equipment by 14.9% (-0.11% CPI effect), and television sets, video discs and computers by 5.6% (-0.07% CPI effect). That said, the effect of sales on clothing and footwear prices was smaller than we had expected; in fact, this was the second-smallest decline in January prices in the past decade. On the other hand, the drop in housewares and electrical equipment prices was unusually large this January – the largest yet seen this century. The surge in the exchange rate since mid-2016 has been a major driver of the price reductions in these last items. It is also the main reason for the decline in motor vehicle prices, which measures 3.4% month-on-month (-0.20% CPI effect) and 7.3% since the beginning of 2016. 

Other downward-pushing items include international airfares, which fell 12.2% (-0.13% CPI effect); postal and telephone services, down by nearly 3.2% (-0.08% CPI effect), and pharmaceuticals and medical products, which fell by 1.2% (-0.02% CPI effect). 

Housing the main upward-pushing factor

Various subcomponents of the CPI pushed upwards in January, however. As before, housing was chief among them. Imputed rent, largely a reflection of housing market prices, rose by 1.3% (0.22% CPI effect), and the housing component as a whole pushed the CPI upwards by 0.35% in January. The housing component has been the main driver of inflation in the recent term, as can be seen clearly in the spread between CPI inflation (1.9%) and CPI inflation excluding housing (-0.9%). Therefore, the impact of housing on inflation is currently 2.8% and has been growing recently.

Petrol prices rose by 3.8% (0.14% CPI effect), both because of the increases in public levies that took effect at the turn of the year and the rise in the ISK price of imported fuel. Public levies also explain the 3.7% increase in the price of alcoholic beverages and tobacco (0.12% CPI effect), including a 7.5% hike in tobacco, which is probably due to the steep increase in the price of snuff. Hotel and restaurant prices also rose by nearly 0.8% (0.04% CPI effect). Food prices were virtually unchanged month-on-month in January, however, as the drop in fruit and meat prices offset the rise in dairy products. 

Inflation modest as long as the ISK strengthens

The outlook is for inflation to remain broadly unchanged in the next few months. Our preliminary estimate is that the CPI will rise by 0.6% in February, 0.5% in March, and 0.3% in April. According to these projections, inflation will measure 2.1% in April 2017. 

On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.18% per month. In February and March, seasonal sale effects will reverse for the most part, although we do expect the price of imported goods such as clothing, furniture, and electrical appliances to be generally lower at the end of the quarter, owing to a stronger ISK and the cancellation of import duties on some of these goods. We also expect airfares to fall in February and then rise again in March and April. 

Further ahead, developments in inflation will be determined largely by the ISK exchange rate. If the ISK appreciates again as summer approaches, inflation can be expected to remain below the CBI’s target for as long as the appreciation lasts. On the other hand, things could turn around swiftly if there is a long hiatus in the strengthening phase or if the ISK weakens again. Domestic cost pressures stemming from steep wage increases and real estate prices are very strong, and they will affect inflation quickly in the absence of the imported deflation we have seen for the past three years.


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