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Icelandic Financial Market Digest 11. apríl

Publisher: Íslandsbanki Research • Resp.Editor: Ingólfur Bender

We forecast a 0.4% rise in the CPI in April

We project that the consumer price index (CPI) will rise by 0.4% month-on-month in April. If this forecast materialises, headline inflation will rise from 1.6% to 1.8%. 

In our opinion, the medium-term inflation outlook has deteriorated somewhat since our last forecast. There are two reasons for this: we expect the exchange rate to be lower than in our previous forecast, and we now anticipate a swifter rise in house prices early in the forecast horizon. That said, we still 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 just over 3.4% in the latter half of the forecast horizon. 

Housing, airfares, food, and accommodation push upwards

The housing component of the CPI has been the main driver of inflation in the recent term and, according to our forecast, will be the strongest upward-pushing item now. Our survey indicates that imputed rent—largely a reflection of developments in house prices—will rise by 2.0% during the month (0.35% CPI effect). This would be the largest single-month rise in this item since 2007, apart from September 2016, when Statistics Iceland (SI) corrected an error from earlier in the year, which meant that the increase for September actually represented a two-month rise. Overall, the housing component will push the index up by 0.34% in April, as reduced prices of imported building supplies lower the maintenance subcomponent slightly. 

The outlook is for a marked rise in international airfares after the decline in March, as a large share of this year’s April measurement includes the Easter holidays. We also expect domestic airfares to rise somewhat. Airfares will contribute to a combined 0.10% increase in the CPI, according to our forecast. We also expect a slight rise in food and beverage prices (0.05% CPI effect), particularly to include vegetables, fruit, and meat. Petrol prices have also risen somewhat since the March measurement (0.03% CPI effect), as the ISK has weakened and global petrol prices have increased in recent weeks. And finally, we expect hotel and restaurant prices to rise slightly in April (0.03% CPI effect), as the peak tourism season is approaching and contractual wage rises are due to take effect in this labour-intensive sector. 

Clothing and other items push downwards

Offsetting the above will be a number of items pulling the CPI downwards in April, particularly to include clothing and footwear (-0.06% CPI effect). There are indications that clothing prices are now falling, including an average price reduction of 11% recently announced by clothing chain Lindex in response to favourable developments in the ISK exchange rate. 

Also, the price of telephone and internet services can be expected to keep falling (-0.03% CPI effect), continuing the trend seen non-stop in the past half-year. We also expect other consumer durables such as motor vehicles and electrical equipment to lower the CPI by an additional 0.04% in April.

Inflation broadly unchanged in coming months

The outlook is for inflation to remain broadly at current levels in the next few months. We project a 0.3% rise in the CPI in May, a 0.2% rise in June, and a 0.2% decline in July, leaving headline inflation at 1.9% by mid-year. 
 
On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.20% per month. We have revised our near-term forecast of house prices upwards, in view of the current housing market situation. We also expect a seasonal rise in airfares in June and July. Seasonal sales will also affect July CPI measurements, as usual. 

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 again. We expect inflation to continue at broadly the present pace through most of this year, remaining below target and measuring 2.2% in December. We forecast that the pace will pick up as the winter advances, however. We project that inflation will overtake the 2.5% target in Q1/2018 and remain above the target over that year, averaging 3.0% in 2018 and 3.4% in 2019. 

ISK exchange rate: a key factor

As usual, the ISK exchange rate is a major determinant in our forecast, and we still expect it to rise until the last quarter of this year. On the other hand, we have revised our forecast downwards and now expect the appreciation to measure just over 4% during the period, owing both to the changed exchange rate environment post-capital controls and to the authorities’ recently stated determination to lean against further appreciation of the ISK. As before, 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. 

The exchange rate path is somewhat lower in this forecast than in our previous one, owing to developments in the past month and changes in expectations for the rest of the year. The exchange rate assumption strongly affects the forecast; for instance, a forecast based on a constant exchange rate at the March 2017 average would push inflation up above the target in Q4/2017 and result in 0.6% higher inflation, on average, throughout 2018. 

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. Uncertainty in the labour market is lower for the near term after it was decided to postpone the private sector wage settlement review. On the other hand, recent developments among large employee organisations have exacerbated upside uncertainty further ahead, with the associated increase in inflationary pressures. 

As is mentioned above, we now expect house prices to rise fairly rapidly in coming months, which pushes our near-term inflation forecast upwards. The increase in house prices will continue thereafter, according to our forecast, although we expect the pace to ease gradually. 

Inflation forecast for April


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