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2021: For the economy, a better year than we dared hope

In many ways, economic developments in 2021 have turned out more positive than they promised to be at the beginning of the year. GDP growth has firmed up more, unemployment has fallen faster, and the ISK has appreciated somewhat more than we anticipated. But inflation has been more stubborn, and the monetary tightening phase has come earlier than we had expected.

The year now coming to a close has certainly seen its fair share of economic ups and downs. Presumably, most observers hoped that widespread vaccination would quell the pandemic over the course of the year, but instead, the world is facing yet another wave – this one in the midst of the holiday season – and in many places the situation is ambiguous.

But even though the Coronavirus did not take its leave in 2021, various aspects of the economy have improved more than many dared hope, and in a number of respects Icelanders are in a better position than we and most others expected at the beginning of the year. It is therefore illuminating to look back at 2021 and compare our initial expectations concerning developments in key economic variables with actual developments and with the outlook as of the year-end.

GDP growth exceeds expectations

If we begin with the GDP growth outlook: according to our macroeconomic forecast from late January, we projected GDP growth for the year at 3.2%. We had expected that this growth would be driven mainly by a rebound in tourism plus moderate growth in consumption and investment. The national accounts for the first nine months of the year are now available, as are statistics indicating probable developments in Q4.

In short, we now expect GDP growth for 2021 as a whole to turn out considerably stronger than we had forecast at the beginning of the year. The difference is attributable to the much greater buoyancy of domestic demand than we had expected. For example, in our January forecast we projected private consumption growth at 1.9%. For the first three quarters of 2021, however, the actual growth rate was 5.4%, and data such as payment card turnover figures and consumer goods imports suggest that growth for the year as a whole could even turn out slightly higher. Developments in private consumption weigh heavily in the GDP growth rate, and by the same token, this difference plays a major role in the underestimation in our January forecast.

A similar tale can be told of investment, which is set to measure much stronger than we had anticipated. In January, we projected investment growth for the year at just under 4%, while the growth rate for the first nine months of 2021 was more than 13%.

On the other hand, the outlook is for export growth to be broadly in line with our early-2021 forecast. Strong growth in domestic demand is accompanied by increased imports, of course, and the contribution of net trade to output growth will not be as favourable as we had projected in January.

The employment situation has improved markedly

The relatively swift economic recovery has resulted in more rapid job creation than looked probable early in 2021, and unemployment has also fallen sooner. In our January forecast, we predicted that unemployment would average 9.6% this year and then taper off to an average of 4.6% in 2022. On the other hand, the jobless rate was already down to 5% by this autumn and has remained there since.

By now, the only figures still outstanding are for December, and the outlook for 2021 as a whole is for unemployment to be consistent with our September forecast. Provided that the recovery of tourism does not suffer a dramatic and prolonged setback next year because of the pandemic, we are optimistic that our September forecast will also be borne out for next year, and that employment will more or less align with the pre-pandemic situation over the course of H2/2022.

ISK develops in line with expectations

At the beginning of 2021, we were guardedly optimistic about developments in the exchange rate, after it fell by nearly 10% in 2020. We considered it likely that the ISK would be under pressure until the tourism industry righted itself, but we expected things to look up when tourist numbers started to rise. At that time, we projected a modest appreciation in 2021 and a more rapid one thereafter.

Early this year, our projection looked set to be on the pessimistic side, as the ISK strengthened by 5% in H1/2021. We updated our exchange rate forecast to reflect this, and in both May and September, we forecast that the ISK would be an average of 3-4% stronger in 2021 than in 2020.

But the second half of this year has developed quite differently than the first half. The ISK sagged in Q3 but has rallied again, starting in early November. The outcome for 2021 as a whole – a 2.5% stronger ISK than in 2020 – therefore appears to be right between our January forecast and our May and September updates. As we have discussed recently, we remain convinced that the ISK has some upside potential in 2022, fuelled by rising tourist numbers rise and a widening current account surplus.

Inflation more persistent than we expected

As regards inflation and interest rates, however, comparing our January forecast with actual developments gives considerably less cause for cheer. In January, we expected inflation to be relatively well-behaved in 2021, as there were signs that the inflation spike following the ISK depreciation in 2020 would soon reverse. But actual developments could hardly have been more different. This year has been Iceland’s biggest inflation year since 2012, with prices rising by an average of 4.4%.

It can be said that our underestimation of 2021 inflation was by and large a reflection of overly modest expectations about domestic demand early in the year and about the position of Icelandic households over the year as a whole. In particular, we did not expect, any more than most other observers did, that the housing market would boom as it has done. At the beginning of the year, we projected that house prices would be an average of 6.5% higher in 2021 than in 2020, whereas they are nearly 13% above last year’s average.  Because house prices weigh heavily in the CPI, the overheated housing market has affected headline inflation.

Furthermore, both foreign prices and shipping costs have developed much less favourably than we had anticipated, as inflation is widely higher than it has been in years, and well above global forecasts for 2021. So we find ourselves in good company with those of our domestic and foreign colleagues who have underestimated the impact that governments’ pandemic response measures, changes in household demand, and imbalances in global production and transport chains have had on inflation in recent quarters –  cold comfort, perhaps, but comfort nevertheless.

Monetary tightening phase came earlier than previously expected

It follows from a more buoyant economy and less favourable developments in inflation that the Central Bank’s (CBI) policy rate has diverged from our early-2021 projections. In January, we considered it likeliest that the policy rate would remain unchanged at 0.75% through the end of 2021. We were of the opinion that the moderate inflation and growth outlook hardly gave the CBI cause to do other than embark slowly and gradually on the monetary tightening phase that lay ahead.

But to make a long story short, rising inflation and signs of recovery in the economy, particularly to include domestic demand, prompted the bank to start raising the policy rate in May 2021. The CBI has raised rates year-to-date by 1.25 percentage points, to the current 2.0%. 

As the signs of economic recovery and more persistent inflationary pressures grew clearer, we updated our policy rate expectations accordingly. We now expect the CBI to continue the tightening phase into 2023 and not stop until the middle of that year, when the key interest rate has reached 3.5%.

Problems notwithstanding, the economy is on a favourable trajectory

Fortunately, the difference between our January forecast and actual developments over the course of 2021 reflect a stronger economic recovery than we had projected. Although persistent inflation and an overheated housing market are certainly worrisome at the moment, they are more preferable than persistent unemployment and weak demand growth.  Another positive angle is that households, businesses, and the public sector are on a generally sound footing financially, and most indicators suggest that all three groups are well prepared to contribute to the continued economic recovery in 2022.

We therefore remain optimistic about the economic outlook for next year, although there are complex issues ahead, such as bringing about a more balanced housing market and finding the economic policy “sweet spot” that allows the accommodative stance to be withdrawn gradually without jeopardising the economic recovery. And last but not least, it will be a complex but important task to steer the upcoming wage negotiations so as to preserve real wages and accommodate the extremely diverse conditions facing domestic firms after the pandemic – and above all else, to avoid ratcheting up the all-too-familiar wage-price spiral. We hope that efforts to tackle these challenges will prove as successful as the battle with the economic repercussions of the pandemic has generally been.


Jón Bjarki Bentsson

Chief economist