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2022: A sunny economy … with cloudy skies ahead

2022 has seen more buoyant domestic demand – private consumption in particular – than we forecast at the beginning of the year. Rapid demand growth has been reflected widely, including in stronger job creation, a hotter housing market, and more persistent inflation than previously anticipated. But even though inflation has been higher and interest rates have risen faster than was assumed at the beginning of the year, households, businesses, and the public sector are generally well prepared to face the adjustment towards economic equilibrium in the year to come.

The year now coming to a close has certainly developed differently than most observers expected in January. Presumably, most were hoping – as we were – that the final chapter of the pandemic would yield to a period of greater equilibrium and less in the way of big news on the global front. Russia’s invasion of Ukraine put paid to those hopes, of course, and the year has been characterised by significant volatility in the global economy and financial markets.

Supply chain bottlenecks, an energy crisis, a commodity shortage, spiking inflation, and rising interest rates worldwide have been the order of the day in 2022, and now, at the year-end, households and businesses in most, if not all, of Iceland’s neighbouring countries are facing the highest inflation they have seen in decades and the highest interest rates in quite some time. Fortunately, the Icelandic economy has by and large weathered the storm, as it is in many ways more heterogeneous than before and is simultaneously more resilient against external and internal shocks.

After this highly eventful year, we thought it appropriate to take a backward glance and provide a quick review of our forecasting record for the year.

2022: the year of great gusto in private consumption

Let us begin by looking at the GDP growth projections we published in our macroeconomic forecast in late January, when we forecast GDP growth for the year at 4.7%. We expected this growth to stem mostly from robust growth in exports, mainly tourism and fishing. We also expected private consumption growth to fuel GDP growth in 2022, while the share of investment would ease markedly relative to 2021.

But now that Statistics Iceland’s (SI) figures for the first nine months and indicators of developments in Q4 are available, it looks as though year-2022 GDP growth will turn out considerably stronger than we envisioned in January, global economic turmoil notwithstanding. Our September forecast for 7.3% GDP growth this year has held up better. The main reason for this is the surge in private consumption, which grew by 10.9% in real terms over the first three quarters of the year, overtaking the January forecast of 4.2% by leaps and bounds. Iceland has not recorded a private consumption growth rate this fast over this nine-month period in 17 years. The fourth quarter was probably more moderate, however. Fortunately, the private consumption boom was based not on a massive increase in household debt but on accumulated savings and – for some wage-earners, particularly those on the lower rungs of the pay ladder – real wage growth. Furthermore, Iceland’s population has continued to grow at a good clip, or 2.5% in 9m/2022, according to SI data.

Growth in investment and exports appears likely to align roughly with our January forecast, although in both cases the growth rate will probably be somewhat stronger than we envisaged initially. On the other hand, import growth looks set to be far stronger than we projected in January.

As a result, the growth outlook for 2023 is rather weaker than is depicted in our January forecast. Signs of expansion can be seen widely throughout the domestic economy, and the outlook is for a shift towards a better balance, with slower growth in demand alongside continued robust growth in exports. GDP growth will probably go hand-in-hand with population growth, and therefore, per capita GDP is unlikely to change markedly between years.

Labour market on the upswing

The stronger-than-expected economic recovery is mirrored in a swift decline in unemployment. At the beginning of the year, registered unemployment measured 5.2%, according to data from the Directorate of Labour (DoL). It had fallen to 3.3% by November, however, and is expected to remain broadly at that level through 2023. As before, we expect a slight uptick in unemployment in 2024, although the overall outlook for the labour market is very good.

The ISK: what goes up must come down?

At the beginning of 2022, we expected the ISK to appreciate decisively during the year, driven by brisk growth in exports. This forecast has materialised for the most part, although intrayear developments have diverged sharply from our projections. Over the first five months of the year, the ISK strengthened considerably, only to lose ground again starting in early summer. The appreciation in H1 was probably due in large part to position-taking with the ISK via forward contracts, while the reversal from June onwards stems partly from unexpectedly unfavourable developments in external trade, as we have discussed recently.

But there are more factors at work, not least the possibility of deleveraging in foreign currencies in the final four months of the year. In other words, it is conceivable that a portion of Iceland’s foreign debt stock is being retired and, as applicable, refinanced in local currency. Data on foreign currency flows and developments in external assets and liabilities will hopefully shed clearer light on this in coming months.

But when all is said and done, the big picture broadly resembles the one we sketched out at the beginning of the year. The ISK exchange rate has been an average of 3% higher in 2022 than in 2021, whereas in January we forecast that it would be 3.5% higher. In the interim, we were somewhat more optimistic about the exchange rate, however, not least because of the ISK appreciation during the first five months of this year. We still believe the ISK has upside potential further ahead, although the near-term outlook is more ambiguous than before, given the unfavourable developments in external trade and other capital outflows in the last third of the year.

Higher inflation, higher interest rates

The part of the January forecast that has stood the test of time the least centres on inflation and interest rates. At the beginning of the year, we thought the inflation spike that had accelerated from mid-2021 onwards would peak, as it stemmed largely from the aftereffects of the pandemic, with prices being pushed upwards by supply chain problems, on the one hand, and stimulative fiscal policy measures, on the other.

But as we all know now, things turned out quite differently. Russia’s invasion of Ukraine pushed oil and commodity prices up rapidly in late winter, and economic policy responses in Iceland and abroad have stimulated demand more strongly than generally expected, especially in the housing market. And it didn’t help that central banks in the world’s largest currency areas allowed themselves to be swayed early in the year by hopes of a short-lived inflation spike. This brief bout of wishful thinking led to a tardy monetary policy response – although not in Iceland, thankfully enough. These developments strongly affected our inflation forecast as early as May, as the short-term global outlook had deteriorated abruptly on the heels of the surge in house prices a few months beforehand.

Since mid-year, however, we have forecast short-term developments in inflation quite accurately, and in fact, our view of the coming term has not changed radically since we issued our September forecast. Headline inflation measured 9.6% in December and averaged 8.3% in 2022 as a whole. We now expect, as we have ever since this spring, that inflation will lose considerable steam in 2023 and measure around 5% in one year’s time.

The darkening inflation outlook and more rapid demand growth than we projected in January have made their mark on the policy rate in 2022 and changed the near-term interest rate outlook. At the beginning of this year, we expected a relatively moderate rise in interest rates and envisaged a policy rate averaging 2.7% in 2022 as a whole. Now, though, it is clear that the policy rate has averaged 4.2% in 2022 and will be somewhat higher in 2023 as well.

Even so, our opinion about developments in the policy rate has not changed substantially since the middle of the year. In September, we forecast that the policy rate would close the year out at 6%, as has indeed happened. Furthermore, there is a strong probability that interest rates will not rise further, as clearer signs of a better balanced housing market and slower demand growth – in recent months and in the quarters ahead – are steadily coming to the fore.

Iceland is booming despite an erratic global economy

To summarise, it can be said that as regards the exports side of the economy, the picture we sketched out in January has largely been borne out, although domestic demand – private consumption in particular – turned out far stronger than we envisioned. The latter is reflected in more a rapid decline in unemployment and more unfavourable developments in external trade than we anticipated in January. The current account deficit – which was also larger than we had forecast – made a stronger mark on the ISK in H2 than we expected after the robust appreciation in H1. A weaker ISK, higher global inflation, and a hotter housing market all affected developments in inflation during the year, calling for a more aggressive response from the Central Bank (CBI) than we had assumed in January.

Although inflation has proven more stubborn and interest rates have risen higher than most observers expected, the Icelandic economy is still on solid ground, and in the main, households, businesses, and the public sector are reasonably well positioned in both historical and international context. Iceland is therefore in a good position to face slower growth and a rebalancing of the economy during the year ahead.


Jón Bjarki Bentsson

Chief economist