In all of the scenarios, fuel prices, airfares, and shipping costs rise in the wake of the hostilities. The main difference among them lies in the scope and duration of the price hikes. Furthermore, the effect on imported goods is far stronger in the negative scenario than in the positive one.

Fuel is the item affected first, and as is well known, fuel prices have already risen because of the war, but the impact differs from one scenario to another. In the positive scenario, fuel prices rise in April and to a lesser degree in May, but the increase will be offset by Government measures. Prices will fall thereafter. In the baseline example, fuel prices continue rising until this autumn, albeit more slowly as time passes, and price pressures will then start to ease.

Based on these simplified scenarios, it can be seen that the gap between them widens over the course of this year: in the negative scenario, for example, the hostilities drag on and inflationary pressures are more persistent, while in the positive scenario the war ends soon and the effects reverse more quickly. The short-term outlook differs as well, as price hikes are considerably larger in the negative scenario than in the positive one.

Wage agreements at risk

There is much at stake in keeping inflation at or below 4.7% by August, as inflation above that level would trigger a review of wage agreements. It is clear that the Government’s newly announced measures, including a temporary reduction in value-added tax (VAT) on fuel, are designed in part to dampen inflation in advance of the important August measurement. Whether the measures will suffice is very uncertain, and the results vary from one scenario to another.

In the baseline example, the forecast assumes that inflation will measure about 5% in August, which means the review clause in the wage agreements will be activated. The review clause will also be triggered in the negative scenario. In the positive scenario, however, inflation is projected to measure 4.5% in August, slightly below the contract review threshold, and wage agreements will therefore hold.

Obviously, the race is on to bring inflation down in the next few months, and it would take very little to derail the effort altogether. Although it has not yet been established whether the review clause would be activated in full, such an outcome would exacerbate labour market uncertainty and undermine economic stability at a delicate point in time.

As this shows, the stakes are high, and near-term developments in the Persian Gulf will be a major determinant of domestic inflation in the months ahead. In the baseline scenario, we assume that twelve-month inflation will measure 4.7% in December, while in the positive example it is projected at 3.8%. In the negative scenario, however, it could be as high as 5.5%. The impact of the war is set to subside gradually over the course of 2027, and the gap in measurements narrows as the period advances.

Although the conflict in the Persian Gulf could strongly affect inflation, as is discussed above, Iceland’s current inflation problem is largely domestic in origin. Services account for most of headline inflation at the moment, or about 4%. Because there is little we can do to affect global developments, it is vital that we look inward and work systematically to mitigate domestic inflation, which is the main source of inflationary pressures at present.