Household and business sentiment darkens

Recent expectations surveys show a significant erosion of households’ and businesses’ optimism about the economic outlook, mainly because of rising inflation, shrinking real wages, and global uncertainty. The outlook for coming quarters is for growth in private consumption and investment to slow markedly, with exports taking over from domestic demand as the main catalyst of GDP growth.

According to the newly published Gallup Consumer Confidence Index (CCI), Icelandic consumers grew distinctly more downbeat in July. The CCI measured 80.6 points during the month, the lowest value since November 2020, when it became obvious that the COVID-19 pandemic would persist far longer than had been hoped earlier in the year. Consumer optimism as measured by the CCI peaked in autumn 2021, but the index has been falling steadily ever since, owing to rising inflation and ever more inauspicious news on the global front. The index fell below the 100-point threshold marking parity between optimistic and pessimistic survey participants in May 2022.

There are a number of explanations for the deterioration of Icelandic households’ expectations in recent quarters. The pandemic upended Icelanders’ lives well into last winter, the war in Ukraine has caused increasing uncertainty and pushed global prices skywards, the Central Bank of Iceland (CBI) has responded to the bleaker inflation outlook with rapid policy rate hikes, and the outcome of this autumn’s wage negotiations is firmly up in the air.

But inevitably, our attention is drawn mainly to inflation as the main cause of the current downturn in sentiment. In Iceland, as elsewhere, high inflation wreaks havoc on the general public, who see the price of necessities and other consumer goods rising steadily at a time when their annual wage increases have already come into effect and no further pay rises are expected in the immediate future.

As the chart indicates, there has generally been a strong correlation between developments in real wages and the CCI. The former is determined to a large extent by developments in inflation, particularly if sudden, unforeseen changes in inflation occur within the term of wage settlements.

Cynics here, doomsters there … pessimists are everywhere
This surge of downbeat sentiment is not confined to Iceland. The situation in neighbouring countries is by and large the same. In many countries, in fact, rising inflation has affected consumer sentiment far more than it has in Iceland, for two main reasons:

  • A sizeable share of foreign inflation stems from steeply rising household energy costs, to which – fortunately – Iceland is more or less immune.
  • In most other countries, consumers are far less accustomed to high inflation than Icelanders are. In Iceland, we need look no further than the late 2000s to find inflation figures much higher than those we see today, while in neighbouring countries a large share of consumers are experiencing the first real inflation shock of their lives after several decades of price stability.

Private consumption growth to lose pace in H2

The CCI is one of the indicators we pay closest attention to when we map out the next few quarters’ likeliest developments in private consumption, as pessimistic households tend to be more frugal while optimistic households spend more freely.

Recent developments in the CCI and real wages suggest that households will grow more reluctant to spend as the year progresses. Even though payment card turnover data for H1 show no signs of dwindling appetite or capacity for consumption, we think private consumption growth will probably lose considerable momentum in coming quarters, perhaps even contracting slightly in Q4, as the effects of shrivelling real wages begin to hit home.

But misery does love company, and households are not alone in their growing pessimism. Among executives from Iceland’s largest firms, the assessment of economic and labour market developments and prospects has deteriorated again, after improving rapidly early in 2021. Even so, the optimists still carry the day, according to Gallup’s most recent measurements for the CBI and the Confederation of Icelandic Employers, published in the late June issue of the CBI’s Economic Indicators.

Corporate sentiment tends to correlate rather strongly with business investment, as companies are more careful with new investment when the outlook is ambiguous. Business investment has been cruising along at a good clip recently, after a dip in 2020, the first year of the pandemic. In 2021, it grew by over 23% in real terms, and in Q1/2022, it grew by 38% overall, and just over 19% if investments in ships, aircraft, and energy-intensive industry are excluded. Based on developments in executives’ sentiment and factors such as rising cost of capital and the uncertain global economic outlook, it is fairly safe to assume that business investment will lose steam later this year.

In our macroeconomic forecast from May, we projected that GDP growth would measure 5% in 2022 and 2.7% in 2023. We also projected that exports – tourism-related services exports in particular – would take over increasingly from private consumption and investment as the main driver of GDP growth over the course of 2022 and would be the leading driver of growth in 2023. We have seen nothing in the past couple of months to shake us loose from this opinion, although the near-term outlook is indeed more ambiguous than it appeared this spring.


Jón Bjarki Bentsson

Chief economist