2023: A year of adjustment for the Icelandic economy

Economic developments in 2023 turned out broadly as we expected in January. Inflation has been more persistent and interest rates higher despite a stronger ISK, however, and the turnaround in the economy has been more abrupt than we forecast at the beginning of the year. In many ways, the outlook is for economic developments in 2024 to mirror those in 2023.

As a new year begins, it is useful for forecasters to take a backward glance at their projections about economic developments and prospects and compare those projections to the most recent data and indicators. Last year proved to be a tricky one for economic analysts around the world, and some of the forecasts published early in the year have turned out well wide of the mark, as is discussed in a recent article in The Economist.

At ÍSB Research, we spent a fair amount of last year preparing forecasts, as is our custom. We published three macroeconomic forecasts: in early February, late May, and late September. In addition, we issued monthly inflation forecasts and published policy rate forecasts about a week before each Central Bank (CBI) decision date.

Our first macroeconomic forecast published in 2023 bore the title “Adjustment phase ahead”, and to cut a long story short, it seems to us that we can be fairly satisfied with the scenario we sketched out then. As we expected, 2023 was characterised by dwindling growth in domestic demand coupled with strong services exports, particularly in tourism and related sectors.

If anything, the shift that took place during the year turned out sharper than we projected at the outset. This applies in particular to private consumption, which is one of the most important subcomponents of the expenditure accounts. Private consumption grew by 4.5% in Q1 but contracted by 1.7% in Q3, the largest single-quarter contraction since early in the pandemic.

A similar pattern could be seen in GDP growth, which measured 7.0% in Q1 but only 1.1% in Q3. Although GDP growth weighed in at 4.2% for the first nine months of the year combined, it is not out of the question that our September forecast of 2.2% output growth for 2023 as a whole could end up reasonably accurate.

Largely because of higher interest rates, we revised our year-2024 GDP growth forecasts downwards as 2023 advanced. But the GDP growth outlook is acceptable nevertheless, and there are few indications that Iceland is facing the prospect of a recession, as some of our neighbouring countries are.

Tight labour market

As we assumed at the beginning of 2023, the labour market has been tight this year. Although tension has eased somewhat in H2 as growth has diminished, unemployment remains low. In this respect, our forecast from early this year has proven quite accurate. Wages have risen more than we anticipated, however, and have been one of the reasons for higher inflation than we expected.

By the same token, the employment outlook for the next few years changed very little over the course of 2023. The outlook is still for a modest rise in unemployment as the economy cools and demand for workers subsides in labour-intensive industries such as tourism and construction. That said, the Icelandic labour market is unusually flexible, and as has often been the case in the past, changes in labour demand may well be met to a large degree with changes in migration to and from the country, a shift in labour market participation among those nearing retirement age, and stronger demand for higher education.

ISK stronger than we had expected

At the beginning of 2023, the ISK had depreciated virtually without interruption since autumn 2022, and as a result, we were far more pessimistic about the ISK exchange rate than ultimately proved warranted. On the other hand, our forecasts from spring 2023 onwards have turned out quite accurate, now that the year is coming to a close. Our recent discussion of the past few months’ exchange rate movements can be found here, but to summarise, the ISK appreciated markedly over the first eight months of the year, only to plummet in September, October, and early November. In the final months of the year, however, it has been relatively stable and the FX market well balanced. Our opinion about near-term exchange rate developments is similarly unchanged: we think the ISK is more likely to strengthen in the coming term than to weaken.

Inflation more stubborn and interest rates higher

Although the ISK exchange rate has been somewhat higher and GDP growth probably somewhat weaker for 2023 as a whole than we had forecast early in the year, inflation has proven far more intractable than we anticipated. This is due in large part to two factors: wages have risen more than we had assumed, and inflation abroad was higher early in the year. By as early as May, however, our assessment of the inflation outlook had grown quite accurate, and the big picture in our forecasts has changed very little since then.

The outlook is for a fairly rapid decline in twelve-month inflation in the first half of 2024, as months from H1/2023 featuring hefty CPI increases will drop out of twelve-month measurements. Furthermore, a more stable ISK, lower global inflation, and a better balanced housing market will foster a slower rise in the CPI in coming quarters. That said, it could prove a Herculean task to bring inflation down from 4%, the upper tolerance limit of the CBI’s target, to the actual target level of 2.5%. Factors that will complicate the process include persistent domestic cost pressures, owing not least to the generous pay rises we have provided for in our forecast, as in recent years.

Even there, however, there might be a light at the end of the tunnel, if recent statements made by the social partners concerning their objectives for the upcoming round of wage negotiations are borne out. As we see it, if the parties concerned can agree on wage rises broadly in line with productivity growth plus the CBI’s 2.5% inflation target, and if firms and public entities make a concerted effort to refrain from raising the price of their goods and services, there will be little to prevent inflation from subsiding to target sooner rather than later.

More persistent inflation has also caused the policy rate to rise more than we anticipated at the beginning of the year, as the chart indicates. By the spring, however, our projections of likely developments in interest rates had moved close to the actual outcome.

As we have discussed recently, the most recent indicators do not provide any rock-solid certainty about whether the CBI’s monetary tightening phase concluded this past August or whether the final brushstrokes are yet to come. If our forecasts of developments in demand, the exchange rate, house prices, and other determinants of inflation and inflation expectations in 2024 materialise to any significant degree, the most likely scenario will feature only a minor rate hike, and that in Q1. Later in the year, we expect the CBI to embark on a cautious monetary easing phase, although interest rates will probably remain high throughout the year.

Will 2024 be a mirror of 2023?

When all is said and done, the broad outlines of year-2023 economic developments are well in line with our forecast from early last year. The economy cooled as the year advanced and exports have taken the lead as the main driver of growth, while inflation has been persistent and interest rates have risen steeply. In many respects, 2024 will probably mirror 2023: presumably, growth will gain steam as the year progresses, demand will gain pace and export growth will ease, inflation will decline, and interest rates will ultimately follow suit. In sum: the outlook for 2024 is generally favourable in spite of everything, for after all, slow and steady often wins the race.


Jón Bjarki Bentsson

Chief economist