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29 May 2019

Has inflation peaked for the present?

The contribution of house prices to inflation has tapered off steadily in the recent term. We expect the Central Bank’s (CBI) inflation target to be within reach by the end of this year.

Statistics Iceland’s (SI) newly published consumer price index (CPI) data contained little in the way of surprises. The main drivers of the rise in the CPI in May were petrol and food prices. The inflation rate is expected to hold relatively steady in coming months, and the inflation outlook has generally perked up with the approval of wage settlements in April. The contribution of house prices to inflation has tapered off steadily in the recent term. We expect the Central Bank’s (CBI) inflation target to be within reach by the end of this year.

According to SI’s figures, the CPI rose 0.2% month-on-month in May, raising headline inflation to 3.6%, from 3.3% in April. The CPI excluding housing also rose by 0.2% during the month, however, and twelve-month inflation thus measured was 3.1%. The May measurement was in line with published forecasts. We had projected a MoM rise of 0.2%, whereas the banks’ forecasts as a whole lay in the 0.1-0.2% range. All major CPI components developed in line with our forecast, and there was little that took us by surprise.

Inflation driven mainly by petrol, housing, and food

The price of petrol was the leader among upward-pushing items in May, rising by 3.1% MoM (0.11% CPI effect), mainly as a result of a marked rise in global fuel prices year-to-date, with the price of Brent crude, for instance, up more than 30% thus far in 2019. The housing component rose by 0.26% (0.08% CPI effect) between months. Of that total, imputed rent, which mainly reflects developments in residential real estate prices, rose by 0.33% (CPI effect 0.05%), and paid rent rose by 0.53% (0.02% CPI effect). In addition, food and beverage prices rose by 0.69% (0.09%).

Airfares fall

The main downward-pushing component in May was airfares, which fell 8% MoM (-0.15%). Airfares rose by 20% in April, owing both to WOW Air’s collapse and to Easter season demand. That increase has now reversed in part, following the usual pattern for May, which often provides a post-Easter lull. It is also quite likely that the market has settled down after the spike in demand following WOW’s demise.

Radical change in composition of inflation

Imported goods prices rose by 0.54% in May, slightly more than in April (0.44%), and have risen by around 3% since mid-2018. In view of the depreciation of the ISK in H2/2018, this is a modest increase — thanks for the most part to stiffening competition in the retail sector and an increasingly gloomy near-term outlook for consumer demand.

The composition of inflation has changed dramatically in the recent term. Of the 3.6% inflation recorded in May, imported inflation accounts for 1.15% and the housing component another 1.3%. Just over a year ago, though, imported goods had a deflationary effect of 1.2%, whereas housing had an inflationary effect of 3%. Domestic goods account for 0.5% inflation in May, and domestic services about 0.6%. Broadly speaking, imports, domestic costs, and housing each account for about a third of inflation at present.

Inflation outlook clearing up

Although inflation rose in May, we think the inflation outlook for coming quarters is improving. We forecast a 0.5% rise in the CPI in June, a 0.1% decline in July, and a 0.2% increase in August, leaving headline inflation at 3.4% in August.

Airfares can be expected to shoot up as summer takes hold, owing to rising fuel prices, peak season demand, and reduced competition with WOW Air’s exit from the stage. Imported inflation due to rising goods prices will continue to taper off, provided that the ISK does not weaken again. We also expect house prices to continue rising at the current pace in coming months.

We then expect inflation to ease in the second half of this year. The new wage agreements appear more conducive to reduced short-term inflationary pressures than we had feared. Private sector wages have therefore developed more favourably in recent weeks. The macroeconomic outlook has dimmed significantly, and diminishing demand pressures in the economy will probably keep wage drift in check and maintain pressure on domestic firms’ mark-ups.

We expect inflation to fall below 2.9% by the end of this year and 2.8% by end-2020. The Central Bank’s inflation target will therefore be within striking distance by the end of this year, if our forecast is borne out.