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Icelandic Financial Market Digest 10. febrúar

Publisher: Íslandsbanki Research • Resp.Editor: Ingólfur Bender

Forecast a 0.7% rise in CPI in February

We project that the consumer price index (CPI) will rise by 0.7% month-on-month in February, leaving headline inflation unchanged at 1.9% and heralding the start of the fourth consecutive year of below-target inflation. 

In our opinion, the medium-term inflation outlook has improved somewhat since our last forecast. This is due mainly to changed assumptions about the exchange rate, as we now expect the ISK to weaken more gradually in the latter half of the forecast horizon than we had previously thought. According to our forecast, inflation will be below target until Q3/2018. At that point, it will rise sharply, approaching the upper deviation limit of the target in early 2019 and then tapering off somewhat. Statistics Iceland (SI) will publish the CPI for the month at 9:00 hrs. on 27 February. 

End-of-sale effects, housing, petrol, and tourism push upwards

End-of-sale effects always affect CPI measurements in February, and we expect them to do so this year as well. This year, however, the impact on the index will probably be markedly less than in 2016. There are two main reasons for this: the ISK appreciation from mid-2016 through December should enable retailers to buy new goods at a much better price than they paid for the goods now on sale, and the discounts on clothing and footwear in last month’s sales were relatively small. We project that clothing and footwear will raise the CPI by 0.19% in February and that furniture, housewares, etc., will raise it by 0.14%. 

As before, we expect the housing component to push the index upwards in February; however, we think the impact will be weaker this month (0.13% CPI effect). This is mainly because our survey indicates that the observed rise in house prices will be more modest, at only 0.6% (0.10% CPI effect). 

International airfares declined somewhat in January, and our survey suggests that they will rise again. Domestic airfares look set to follow a similar pattern, and we project that airfares as a whole will push the CPI up by 0.07% this month. And finally, expect the rise in petrol prices since the last CPI measurement to raise the index by 0.03% this month. 

This time, there are few items making a discernible downward impact on the CPI. That said, we expect telephone services prices to continue falling (-0.02% CPI effect), together with motor vehicles and spare parts (-0.02% CPI effect) and pharmaceuticals and medical products (-0.01%). Inflation broadly unchanged into the spring
The outlook is for inflation to remain broadly unchanged in the next few months. We expect the CPI to rise by 0.3% in March, 0.3% in April, and 0.3% in May, leaving headline inflation at 1.9% in May.  

Inflation broadly unchanged into the spring

The outlook is for inflation to remain broadly unchanged in the next few months. We expect the CPI to rise by 0.3% in March, 0.3% in April, and 0.3% in May, leaving headline inflation at 1.9% in May. 

On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.17% per month. In 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 rise in March and April and then fall again in May. And last but not least, we expect hotel and restaurant services prices to spike in May, as the peak tourist season approaches.

Inflation to remain below target through autumn 2018

The outlook is for domestic inflation to remain moderate over the forecast horizon, as long as the ISK does not weaken again. We expect it both to average 1.9% in 2017 and to measure 1.9% at the year-end. We project that it will pick up thereafter, overtaking the Central Bank’s (CBI) 2.5% inflation target in Q3/2018 and approaching 4.0%, the upper deviation threshold of the target, in the first quarter of 2019. After that, we expect it to taper off again, to about 3.2% by the end of the forecast horizon. The uncertainty in the forecast naturally increases further out the horizon, however. 

The ISK exchange rate remains one of the main variables in our forecast, and we have made a few changes in our exchange rate assumptions. We now project that the ISK will strengthen by just over 6% from the current level between now and Q4/2017. As before, we assume that the exchange rate will fall gradually over the latter part of the forecast horizon, as GDP growth slows and the effects of a high real exchange rate grow stronger. We now assume a slower depreciation than in our last forecast, with the real exchange rate holding virtually unchanged. In spite of this, the nominal exchange rate will be somewhat above the current level by end-2019 if our forecast materialises. It should be noted that in comparison with the CBI’s newly published forecast, we expect the ISK to be markedly stronger this year and next, but somewhat weaker in 2019. To a large extent, our inflation forecast and the CBI’s reflect this difference in exchange rate assumptions, as we forecast lower inflation this year and the CBI expects lower inflation in 2018 and 2019. 

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. We expect house prices to follow a similar pattern, continuing to rise but at an increasingly slower pace.

February 2017 inflation forecast

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