At the same time, interest rates had been cut to a historical low, and financing terms were more favourable than before. Demand for real estate surged, and house prices did likewise. Added to this was the Government’s response to the volcanic activity on Reykjanes peninsula, which included a large-scale buy-up of residential housing from Grindavík residents. As a result, inflation in Iceland was no longer a predominantly imported phenomenon but instead was largely demand-driven.

Six years of above-target inflation

Now, six years after inflation started to gain steam, we are still battling the same problem. Even though inflation has tumbled from its last peak, it has been enormously difficult to bring it within striking distance of the target.

Numerous shocks, domestic and foreign, have struck over this period. The main shock unique to Iceland was the spate of earthquakes and volcanic eruptions on Reykjanes peninsula, which delayed disinflation, although overseas wars and heightened global economic uncertainty have also affected prices in Iceland.

The CBI has responded by raising interest rates sharply. Inflation finally started to yield, and for a while in 2025 it hovered around 4%, the upper tolerance limit of the inflation target. It has been heading upwards again since year-end 2025, however, and hit a two-year high this August. This gives rise to an important question: What is causing this inflation, and why has it been so hard to bring it back to target?

Services inflation at the centre of the stage

At present, services prices are the main antagonist in the inflation drama. Of the 5.6% headline inflation rate, about 5 percentage points can be attributed to services items. In other words, services are responsible for about 89% of total inflation.

In general, services prices are stickier than goods prices. This is because the price of services depends largely on wage costs, which are naturally more inelastic than, for instance, the global price of commodities and other inputs, with its propensity to fluctuate widely. The past years’ steep pay rises have probably contributed to ongoing inflationary pressures. As a result, services inflation often tapers off more slowly than inflation caused by temporary supply chain volatility, the ISK exchange rate, or commodity prices. Wage agreements therefore have a major impact on developments in services inflation. Unlike many of the determinants of goods prices, wage developments are often a known quantity for a period of time stretching into the future, particularly when long-term wage agreements are made. This can cause services inflation to be more predictable than it would be otherwise.

Housing

Housing is the single largest services item in inflation, accounting for about 1.7 percentage points of the current 5.6% headline rate. The contribution from the housing component has been broadly at this level in recent months and explains just over 30% of total inflation. At the peak, however, over half of headline inflation was due to housing. Although housing is still the single largest inflation component, it carries is far less weight now than when inflation was at its peak.

Housing has a significant impact on the CPI, as the housing component carries the most weight in the index. The largest subcomponent of housing is imputed rent, which currently weighs just under 21% in the CPI. This reflects how large a share of household spending is due to housing costs.

In order for inflation to return to target, it is important to slow down the increase in imputed rent. There are signs of improvement on the horizon, though, as the real estate market has cooled substantially in the recent past and real house prices have begun to fall. Imputed rent has been quite stubborn, however, and has risen persistently.

One explanation for this could be that Statistics Iceland (SI) changed its imputed rent calculation methodology in 2024 and now relies on developments in rent prices rather than house prices. Since that change was put into effect, rent prices have fallen more slowly than house prices, and imputed rent has fallen more slowly still. Thus the impact of housing on inflation has tapered off more gradually than it would have otherwise.

The large share of inflation-indexed rental leases could explain this to some extent. Such leases adjust automatically with changes in the CPI and can therefore create a spiral between rent prices and inflation. This may explain why imputed rent has been more tenacious than might be expected based on developments in rent prices.

Public services

Public services account for 1.3 percentage points of twelve-month inflation, thereby contributing more than any other item except housing. Public services include a range of services provided by central and local governments, from education and healthcare to waste collection and other basic services.

Unlike the housing component, the contribution from public services has been on the rise recently, taking its biggest jump at the turn of the year. In 2023-2025, public services accounted for an average of 9% of headline inflation, whereas now it contributes nearly one-fourth.

This change is due in part to the adoption of the per-kilometre charge for motor vehicle use at the start of this year. With that change, petrol and diesel fuel fees were shifted from the imported goods category to the public services category, causing the contribution of public services to inflation to expand accordingly. In addition, various fee schedules set by central and local governments or service providers owned by them have risen in excess of the inflation target, including the price of indoor heating, water utilities, and registration at public universities. Because of this, public services now contribute far more to inflation than they did previously.

Other services

The category other services covers a range of services apart from housing, public services, and tourism. Among them are restaurants, hair salons, dentists, motor vehicle repair, and other specialised services. This category explains about 1 percentage point of twelve-month inflation, or just under 18% of the headline rate.

The contribution from other services has been shrinking in the recent term but has held more or less flat in 2026. Movements in the price of these items depend largely on domestic cost factors – wages in particular – and are often a reliable barometer of underlying inflationary pressures in the economy. When inflation has been high for some time, price hikes are generally more frequent, and it becomes easier for firms to pass cost increases through to prices. This can cause services inflation to be more persistent than it would be otherwise.

Goods price inflation: a thing of the past?

Goods prices, too, depend on wage costs, but they are also determined by the ISK exchange rate and the price of energy and inputs. Prices mushroomed during the pandemic and in the wake of Russia’s invasion of Ukraine, when supply chains seized up, shipping costs surged, and the ISK depreciated. Goods price inflation then tumbled as supply chains normalised and global price pressures abated.

As a result, the contribution of goods to inflation has shrunk in the recent term. Goods now account for about 0.6 percentage points of twelve-month inflation, only a fraction of the contribution from services items. At present, imported goods lower inflation by 0.3 percentage points, owing largely to the aforementioned transfer of petrol and diesel fees to the public services category. Domestic goods explain about 0.6 percentage points of inflation, and goods in mixed categories account for another 0.3 percentage points. Although inflation was previously driven to a large extent by foreign factors, it is now primarily domestic and services-driven.

The ISK has held relatively stable in the recent past, in a departure from the pattern typical of previous inflation episodes. Furthermore, imported inflation has been fairly moderate, despite continuing uncertainty about tariffs and international conflicts. The risks remain, however. A depreciation of the ISK or a steep rise in energy or shipping costs could reignite imported inflationary pressures and slow down disinflation in Iceland.

The road to the target

It is clear that the main challenge to be faced is services inflation, which is widespread and stems from housing, public services, and other services. This makes the inflation problem a thornier issue than before, when inflation was driven mostly by temporary shocks.

Nevertheless, it must not be forgotten that inflation has fallen far below its early-2023 peak of over 10%. Yet the last leg of the journey to the target often proves the most onerous. It is usually easier to bring inflation down from 10% to 5% than from 5% to 2.5%. The former phase is usually characterised by a reversal of temporary effects, while the latter requires a rebalancing of inflation expectations, wage growth, and public and private sector pricing.

There are certainly bright spots on the horizon. The economy has begun to slow, as can be seen in a growing slack in the labour market and smaller hikes in real estate prices. This should help to ease inflationary pressures. On the other hand, inflation expectations are still well above the CBI’s target; indeed, they are probably one of the most salient concerns at the moment.

Wage agreements during the period ahead are therefore highly important. Achieving price stability depends not only on interest rates and their impact on domestic demand and saving, but also on whether the interactions between wage developments, firms’ pricing, and public sector fee schedules support continued disinflation. This requires several things: the rise in housing costs must continue to lose pace, public services must not exacerbate inflationary pressures further, and hikes in other services prices must yield. If this can be done successfully and inflation expectations move closer to target levels, there is a strong probability that inflation itself can finally be realigned with the CBI’s 2.5% target.