Fuel prices rise … and rise again

Transport will have the most impact on the CPI during the month, owing primarily to the steep rise in fuel prices. According to our measurement, fuel prices will jump 12.9% MoM (0.34% CPI effect). Furthermore, our forecast indicates that airfares will rise by 3.9% (0.10% CPI effect). The uptick in airfares is considerably smaller than is typical for April, as SI’s price collection period took place after the Easter holidays this time. We expect fuel prices to continue climbing in the months to come. On the other hand, value-added tax (VAT) on fuel will fall in May, as is discussed more fully below.

Other items rise modestly

Food and beverages rise in price by 0.4% MoM (0.06% CPI effect), according to our measurement. This is a smaller increase than in recent months, but because a large share of food products are imported and therefore sensitive to price movements abroad, we expect them to trend upwards in coming months. According to our forecast, clothing and footwear prices will rise by 0.9% (0.03%), and furnishings and household equipment will increase in price by 0.7% (0.03%).

The positive part of the measurement is that the housing component looks set to remain steady for the time being. We expect imputed rent to increase by 0.2% (0.04%) and rise very modestly in the months thereafter.

Government measures

The Government announced temporary anti-inflation measures last Friday. The one that will affect inflation the most is the reduction in VAT on fuel from 24% to 11%. According to our calculations, this will reduce fuel prices by around 10%, thereby lowering the CPI by 0.3%. This particular measure will take effect in May and expire at the end of August. The impact will therefore be temporary, and in our forecast, we assume that headline inflation will be 0.3% lower while the measure is in place.

The inflation outlook

We have updated our inflation forecast to reflect developments in the Persian Gulf. In a recent analysis, we explored the subject of how quickly markets will recover after the war is over. Despite the ceasefire, the situation in the Gulf remains fragile, and shipping traffic through the Strait of Hormuz is still very limited. Our preliminary forecast for the next three months is as follows:

• May – CPI to rise 0.1% (twelve-month inflation 5.0%): The reduction in VAT on fuel from 24% to 11% will offset upward price pressures. Food prices will start rising, however.
• June – CPI to rise 0.60% (twelve-month inflation 4.8%): Fuel prices rise, but less strongly. Airfares and restaurant/accommodation prices rise due to seasonal fluctuations. Imported goods prices rise marginally.
• July – CPI to rise 0.30% (twelve-month inflation 4.7%): Airfares rise due to seasonal fluctuations. Summer sales on key items.

If our preliminary forecast materialises, inflation will measure 4.7% in July. Nevertheless, we expect imported goods prices to keep climbing during the months thereafter, although fuel prices will start tapering off. According to our preliminary forecast, inflation will inch upwards in August and rise still more in September, when the Government measures expire. Based on these assumptions, inflation will exceed the 4.7% threshold triggering the wage agreement review clause.

It should be noted that the inflation outlook is highly uncertain. Because of this, we have developed scenarios that all reflect developments in the Persian Gulf war. Uncertainties lie especially in prospects for fuel prices, shipping costs, and the effects of both on the price of goods imported to Iceland. There are three scenarios: a baseline, reflecting the inflation forecast described above, and two alternative scenarios, one positive and one negative.

Scenarios

In the baseline scenario, the two-week ceasefire that started on 8 April will not prove sufficient to guarantee normal traffic through the Strait of Hormuz in the coming term. Shipping will therefore remain restricted, and uncertainty will be very pronounced. The situation will not normalise until 10-14 weeks have passed. Global fuel prices will therefore remain high well into summer before easing again. In Iceland, the effects will show mainly in higher fuel prices and airfares, plus rising shipping costs, which to some extent will spill over to imported goods prices. Furthermore, a shortage of key industrial commodities will push goods prices higher. Pressures will ease towards the end of summer as supply chains recover.

In the positive scenario, the Strait of Hormuz will open up soon and shipping traffic will gradually return to the status quo ante. Disruptions in supply will prove short-lived, and the situation will normalise within 6-10 weeks. The impact on prices will be limited to the next few months and will show mainly in transitory hikes in fuel prices, airfares, and shipping costs. The increases will also be more modest than in the baseline forecast. This is actually the scenario that was hoped for when the hostilities continued and the ceasefire was announced.

The negative scenario assumes that disruptions will be more protracted, not unlike those caused by the war in Ukraine. Fuel prices will remain high for at least six months, and cost hikes will pass more strongly through to shipping costs and imported goods prices, including food. Reduced supplies of commodities for industrial manufacturing will have a similar impact. The effects will gradually spread to more components of the CPI and will show in stronger imported inflationary pressures over a 6- to 12-month period.

Based on these three simplified scenarios, it can be seen that the gap between them widens over the months to come, as the war drags on in the negative scenario but ends quickly in the positive one. Headline inflation therefore develops in differing ways. In the baseline scenario, we expect twelve-month inflation to measure about 4.7% by December. In the positive scenario, it could fall to 3.8%, while in the negative one it could rise as high as 5.5%. Clearly, there is much at stake, and developments in the Persian Gulf will be a major determinant of domestic inflation in the months ahead.

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