Unusually large seasonal surge in airfares

The largest contributor to this month’s rise in the CPI – and the main reason for the deviation from our forecast – was an unexpectedly steep increase in international airfares. Airfares typically rise in June, and even more in July, when overseas travel hits its peak. This year, the June increase measured 12.7% (0.27% CPI effect), whereas we had projected a rise of 5.5% (0.12%). It is the biggest June spike in airfares in years, the biggest spike since the 15.2% MoM rise in June 2018. Because of this sudden jump, we expect airfares to rise less sharply in July, as a goodly portion of the summer increase has already come to the fore and other factors – lower oil prices, for instance – will tend to keep fares in check.

Fuel, another subcomponent of travel and transit, fell by 0.57% during the month (-0.02%), in line with our forecast. Oil prices have fallen on the whole in the past few weeks but have fluctuated widely. The weakening of the US dollar versus the ISK has amplified the price drop in ISK terms. There is hope that the global market price of oil will remain close to its current level through the summer and then start to fall in the autumn. The outlook is highly uncertain, although it has firmed up in the past few days. Prices have fallen far more in global oil markets than at the filling station in the past few months, though, and we therefore hope the price of petrol and diesel will keep easing as the year advances. Among other things, such a turn of events could cause airfares to develop more favourably.

The price of hotel and restaurant services generally rises as well during the peak summer season, and this year is no exception. In all, hotel and restaurant prices increased 2.3% (0.12% CPI effect) in June, in line with our forecast.

Rise in food prices and imputed rent

Imputed rent rose by 0.7% MoM (0.13% CPI effect), as we had projected. We attribute this to the seasonal effects of increased short-term rentals during the summer, which puts pressure on the supply of rental housing. We consider this CPI subcomponent rather uncertain, as it has proven tricky to forecast it since the new calculation method was adopted a year ago.

Once again, food and beverage prices rose in excess of forecasts, increasing by 0.54% (0.08% CPI effect), as compared with our forecast of a 0.3% rise (0.04%). The main contributors were higher prices for meat, milk, cheese, eggs, and fruit, as well as a marked increase in coffee, tea, and cocoa prices.

Food prices have risen steadily this year, more often than not outpacing forecasts by a fairly wide margin. This is due to a range of cost increases, primarily in wage costs, but higher electricity prices also push manufacturing costs upwards. Presumably, the stronger ISK has had some offsetting effect, as domestic goods have risen considerably more in price than imported goods have. We think it possible that the surge will soon lose steam and that food prices will start easing in H2.

Composition of inflation

Developments in the composition of headline inflation can be seen in the chart below. Of June’s 4.2% inflation rate, the housing component is the single largest contributor, at 1.7%. The contribution of housing to inflation has been subsiding, however. In June 2024, it accounted for 2.7% of the headline rate, and by August of that year that figure had risen to 3.2% before starting to taper off. Services prices are the second-strongest driver of overall inflation, at a total of 1.2%, and rose the most between months. Domestic goods account for 0.8% and imported goods 0.3%. The main catalysts of inflation are therefore housing and services, whereas imported goods and housing were previously the primary drivers.

The inflation outlook

According to our preliminary forecast for the months ahead, the CPI will rise 0.1% in July, 0.3% in August, and 0.2% in September, pushing headline inflation to 4.5% by September. We have lowered our monthly forecast for July, as we expect a smaller rise in airfares after this month’s unexpected spike.

Our forecast for the summer suggests that inflation will ease slightly from the current level, measuring 3.8% in July and 4% in August. It will pick up again in the autumn, when one-off items from last year, including the full subsidy of primary school meals, drop out of twelve-month measurements.

As we see it, the main uncertainty in coming months centres on imputed rent, which rose more than projected in April and May but was consistent with our forecast in June. Added to this is uncertainty about world trade and whether higher US tariffs on Iceland’s EU trading partners will be implemented.

Policy rate set to hold steady through the year-end

Today’s inflation figures are yet another indicator that is unlikely to be a source of relief to the CBI’s Monetary Policy Committee (MPC). Since the May policy rate decision, new measurements have shown stubbornly high inflation expectations, as we have recently discussed. Furthermore, the national accounts for Q1/2025 showed that domestic demand is quite resilient, and recent data such as payment card turnover, new motor vehicle registrations, and overseas travel indicate undimmed appetite for consumption this spring. Added to that are the still-brisk labour market and continued demand for housing despite fairly high interest rates.

In its May statement, the MPC said outright that further policy rate cuts would depend on whether inflation moved closer to the Bank’s 2½% target. In view of our above-described inflation forecast and the continued resilience of the economy, we have updated our policy rate forecast for the coming term. We now expect the policy rate to remain unchanged at 7.5% through the year-end. It should start to fall again in 2026, but probably at a relatively slow pace unless the economic outlook deteriorates markedly.