Economic review 2021

After a deep contraction in 2020, the economic recovery took root in 2021. Domestic demand gained considerable traction, supported by the Government’s economic policy response, an improving labour market, and a sound financial position among most households and businesses. In spite of a small current account deficit, exports also gained ground. The outlook is for output growth to accelerate further in 2022.

The year 2021

GDP growth firmed up again in 2021, after a 6.5% contraction in 2020. The growth phase began in Q2, and GDP growth for the year is estimated at 4.1%. 

The main driver of growth has been the surge in domestic demand, which in turn stems from strong growth in private consumption and corporate and public investment. Households and businesses benefited from, among other things, Government and Central Bank’s pandemic response measures, improvements in the employment situation in labour-intensive sectors, and strong private sector balance sheets at the beginning of the pandemic. 

Private consumption is estimated to have grown by more than 5% in 2021. Consumption has increasingly shifted out of the local economy, including overseas travel and major consumer goods such as motor vehicles. Households have been buoyed up by a number of factors: rising real wages (despite high inflation), declining unemployment, favourable interest rates, rising asset prices, and accumulated savings. 

Total investment looks set to have grown by almost 12% during the year, driven mainly by business investment; however, public investment has steadily gained momentum since the Government launched its investment initiative. Residential investment contracted in 2021, however. 

External trade in balance despite shocks 

Even though the pandemic affected 2H2021 more than had been hoped, the tourism sector has rebounded to an extent. Roughly 700,000 foreign tourists visited Iceland in 2021, about 46% more than in 2020, although only a third of the 2019 total. Other exports also grew apace in 2021, including exports of other types of services, as well as marine products and industrial goods. In all, exports grew by just over 13% during the year, 

but even so, there was a modest current account deficit. Imports of goods and services were up more than 18%, fuelled by imports of consumer goods and investment inputs, as well as services. Although the income account surplus somewhat offset the deficit on goods and services trade, the current account deficit for the year came to roughly 2%. Even so, Iceland’s international investment position improved during the year, with external assets exceeding external liabilities by 41% of GDP at the year-end. 

Labour market rebounds strongly

Developments in the labour market exceeded expectations in 2021. Unemployment fell by more than half over the course of the year, from just over 11% to 5%, although 2.5% of the labour force were still protected by hiring subsidies and other job-related labour market measures at the end of the year.  

Wages also rose steeply in 2021, led by the public sector, although private sector wages increased markedly as well. Even though inflation was high at the end of the year, real wages rose by an average of just over 2% over the course of 2021. Because unit-based pay hikes were the rule rather than the exception, lower-paid workers saw the largest proportional real wage growth, while real wages for higher-paid workers remained flat or declined marginally. 

Inflation and policy rate on the rise in 2021

In trade-weighted terms, the ISK was an average of 2.5% stronger in in 2021 than in 2020. Early in the year, the Central Bank supported the ISK significantly by selling foreign currency from their international reserves. In 2H2021, however, the foreign exchange market was generally well-balanced, and the bank intervened far less. In all, the Central Bank sold just over EUR 140m from the reserves in 2021, as compared with more than EUR 830m in 2020.  

Even though the ISK appreciated in 2021, inflation rose from 4.3% to a year-end rate of 5.1%. This was in line with the international pattern, with inflation surging in most countries. The composition of inflationary pressures changed greatly during the year. Whereas import prices were the main cause of inflation in 2020, the housing component took the lead over the course of 2021. Growing domestic cost pressures could also be seen in rising domestic services prices, and price hikes abroad – including rising fuel prices – pushed inflation upwards in 2H21.  

Rising inflation, together with signs of recovery in the economy – particularly to include domestic demand – prompted the Central Bank to embark on a monetary tightening phase in May 2021. The bank raised the policy rate by a total of 1.25 percentage points in 2021, to 2.0% at the year-end. The short-term real rate was still considerably negative at the end of the year, however, and the monetary stance remains accommodative despite the nominal rate hikes.  

Strong GDP growth expected in 2022

GDP growth is expected to be relatively strong in 2022, at 4.7%, fuelled mainly by exports but supported as well by robust private consumption growth and modest investment growth. The pandemic could have a major impact on how quickly tourism recovers, but the sector appears set to grow by leaps and bounds during the year. Furthermore, the outlook is for a significant increase in marine product exports, owing in part to a strong capelin season and increased aquaculture output. On the other hand, the outlook is also for strong growth in imports of export-related inputs, as well as imports relating to growing domestic demand.  

Rising real wages, a more favourable employment situation, and population growth are expected to underpin a large share of the strong private consumption growth projected for 2022. In addition, residential investment is likely to rebound later in the year, albeit offset by declining public investment further ahead. On the other hand, business investment is expected to contract modestly vis-à-vis last year. An increased supply of new flats and rising mortgage lending rates will probably dampen house price inflation as the year progresses. 

Unemployment will probably ease steadily as labour-intensive sectors such as tourism and construction gain steam. The outlook is also for robust wage growth in 1H, as the contractually agreed GDP growth supplement for 2020 will probably be paid in May, on top of the unit-based pay hike that took effect at the beginning of the year. There is marked uncertainty further ahead, however, as most workers’ wage agreements expire late in 2022. 

Export growth and a stronger current account balance will probably lead to an appreciation of the ISK over the course of the year. A stronger ISK and more stable imported goods prices, together with slower house price inflation and economic policy restraint, will probably cut into inflation, which could be close to the Central Bank’s 2.5% inflation target by the end of 2022. The Central Bank will probably have to keep raising interest rates throughout the year in order for this to materialise, however. 

Although the pandemic has proven more persistent than expected and the end is not yet in sight, the strong position among households, businesses, and the public sector, together with a decisive economic policy response and successful public health measures, has cushioned against the blow and boosted the economy’s growth potential for the coming term.