Icelandic Financial Market Digest 27. október

Publisher: Íslandsbanki Research • Resp.Editor: Ingólfur Bender

Unexpected inflation spurt in October

An unexpected jump in food prices was the main cause of a larger-than-forecast rise in the consumer price index (CPI) in October. Just as noteworthy was a month-on-month slide in house prices according to Statistics Iceland’s (SI) measurements. The outlook is for inflation to remain below the Central Bank’s (CBI) inflation target for the remainder of the year, but today’s CPI measurement will probably complicate the CBI’s interest rate decision next month. 

According to newly released figures from SI, the CPI rose 0.47% MoM in October, raising twelve-month inflation from 1.4% in September to 1.9%. This is the highest inflation measurement since April 2017, although it is quite moderate in historical context. The CPI excluding housing rose by 0.63% during the month, however, and twelve-month inflation thus measured was -2.3%. The spread between inflation measurements including and excluding housing has therefore narrowed somewhat. 

The October CPI measurement is well above published forecasts. We had projected a rise of 0.3% between months, whereas forecasts as a whole lay in the 0.2-0.3% range. The main difference between our forecast and SI’s figures lies in the surge in food prices, where we had expected a decline. Another unexpected development was the slight drop in imputed rent, which did much to offset the spike in food prices. 

Largest MoM rise in food prices in nearly two years

Food and beverage prices rose by 1.9% in October (0.24% CPI effect), the largest MoM rise since the value-added tax rate on food was raised from 7% to 11% at the beginning of 2015. We had projected a 0.5% decline in food prices, and the increase took us quite by surprise. The rise extends to all key subcomponents, in a sharp turnaround after a virtually unchecked downward trend over the past twelve months. In spite of the increase this month, however, food prices have fallen by 2.2% in the past year. Recent news reports state that retailer Costco, which has strongly affected the food market since it opened this past spring, has raised prices on a number of products. Although the store itself is not included in SI’s price measurements as yet, we think it possible that other players in the market may have responded to the news by raising their own prices after the slide in the past few quarters. 

House prices down in October 

The housing component has been by far the most important driver of the rise in the CPI in the recent term. In October, however, the housing component actually kept the CPI in check. The housing component as a whole rose by 0.11% (0.04% CPI effect). On the other hand, imputed rent, which mainly reflects developments in house prices, fell by 0.22% (CPI effect -0.04%). This is the first decline in imputed rent since June 2015, although the pace of the increase has eased in the recent past. 

A decline of 0.2% in capital area condominium prices was the main factor in the reduction in imputed rent, although other subcomponents also fell marginally. Declining real mortgage lending rates also contributed to the slight decline in imputed rent. 

According to SI’s figures, residential property prices have risen by nearly 19% in the past twelve months. Even though the twelve-month pace of the rise in house prices is at its slowest since this past March, the year-on-year rise is still a large one. It will be extremely interesting to track developments in the housing market in coming months, although it should be noted that numbers can fluctuate widely from one month to the next. 

Airfares up; package tour prices down

Although the above-mentioned factors were the main drivers of the October CPI, other items also had some effect – upward or downward. Among those pushing the CPI upwards, airfares rose by 6.9% in October (0.08% CPI effect), petrol prices were up 0.8% (0.01%), and motor vehicle prices rose 0.2% (0.01%). Furthermore, cosmetics prices rose 1.8% (0.04%), and pharmaceuticals and medical products were up 1.4% (0.02%). 

Items pulling in the other direction included spare car parts, which fell in price by 2.4% (-0.04% CPI effect); accommodation, which declined by 0.6% (-0.01%); package tours, down 1.1% (-0.02%); and telephone services, which fell 1.2% (-0.02%). 

How will the Central Bank interpret these developments in inflation?

The outlook is for a slight uptick in inflation over the next few months, although the headline rate will remain modest, in our opinion. We forecast that the CPI will rise 0.1% in November and 0.4% in December, leaving headline inflation at 2.3% by the end of the year. 

On average, the housing component will be the main driver of the rise in the CPI over the period, contributing about 0.2% per month. Even so, this is considerably less than in the first half of the year. Furthermore, we expect the usual seasonal surge in airfares in December. 

It will be interesting to see how the CBI’s Monetary Policy Committee (MPC) responds to this newest twist in the CPI when it sets interest rates on 15 November. In its rationale for the unexpected rate cut in early October, when headline inflation measured 1.4%, the Committee mentioned that “[m]easures of underlying inflation are even lower, and falling." The sudden surge in food prices in October is a rude contradiction of the MPC's stance, even though inflation excluding the housing component of the CPI is still firmly in negative territory. Furthermore, the real policy rate in terms of past inflation has fallen since the MPC’s last interest rate decision, even though it is more or less unchanged by other measures. 

On the other hand, the Committee’s expectations from early October – of a slowdown in housing inflation – are materialising convincingly, at least for the present. That said, it should be borne in mind that imputed rent has a tendency to behave erratically from time to time, and we think the next few months’ CPI measurements will shed clearer light on whether the current surge in house prices is at an end or not. If so, inflation could taper off markedly in coming months. 

This month’s CPI measurement therefore clouds the picture drawn by the MPC early this month. Neither does it help that the Committee’s forward guidance has been of little use recently and its assessment of the relative weight of key determinants has been subject to significant change.



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