House prices still on the march

House prices will probably be a major driver of the April rise in the CPI, as they have been for the past year. According to our forecast, the housing component as a whole will rise by 1% (0.33% CPI effect), mainly because of imputed rent, which we expect to jump by 1.6% MoM (0.28%). In addition, we project that the home repair and maintenance subcomponent will rise by 0.8% (0.04%), driven by an increase in the building cost index in recent months.

In the past twelve months, house prices nationwide have risen by 19%, the fastest pace since autumn 2017. It is important for the CPI that house price inflation should ease soon, thereby offsetting the effects of higher imported inflation. Be that as it may, house prices do not seem likely to slow down their upward march to any marked degree in the near future – at least not before more new properties are put on the market later this year.

Imported goods prices on the rise

Apart from housing, the travel and transport component is the main driver of the month’s rise in the CPI. The component as a whole is set to rise by 0.7% (0.10% CPI effect), according to our forecast. The main upward-pushing subcomponent is airfares, which we expect to increase by 4.9% in April (0.08%) and keep rising in the months to come, driven by greater demand and higher fuel prices. Icelandic petrol prices rose nearly 8% in March, owing to the war in Ukraine, although they have been less volatile in April to date. According to our measurement, petrol prices will rise by only 0.5% (0.01%) this month.

Food and beverages also weigh heavily in this month’s CPI measurement, rising by 1.5% (0.22% CPI effect), according to our forecast. This is due mainly to the increase in dairy product prices announced by the agricultural pricing committee, effective 1 April. A number of other foodstuffs have risen in price as well, including grains, meat, and fruit.

Additional upward-pushing items are hotel and restaurant services, up 1.0% (0.04%), and other goods and services, up 0.4% (0.03%).

Will inflation break the 10% barrier?

Many commodity prices have soared since the war in Ukraine began, and the pandemic is still affecting supply chains and shipping all over the world. The outlook is for inflation to remain high in the coming term and not subside to any marked degree until next year. In our short-term forecast, we project that the CPI will rise by 0.8% in May, 0.6% in June, and 0.3% in July, pushing headline inflation up to 7.7% by July.

Many observers have been pondering whether inflation will move into double-digit territory in the months to come. The last time Iceland saw an inflation rate above 10% was in September 2009, and our current forecast assumes that it will top out at 7.7% in July and then taper off slowly and steadily. But uncertainty is certainly pronounced at present, not least as regards the persistence of foreign price hikes and the degree to which the ISK will appreciate to offset them.

In order for inflation to measure 10% in six months’ time, for instance, the CPI would have to rise each month by nearly 0.4% more than we have forecast. For the sake of the exercise, we looked at the key items that imported inflation usually affects quickly, and we examined how much these items would have to rise in price in order to push inflation over the 10% threshold by September. Other CPI items would change in line with our forecast.

Imported inflation will presumably affect these four components first and then spread to other items. As the chart shows, these components would have to rise well in excess of our forecast in order to cause double-digit inflation.

Imported inflation currently accounts for about one-fourth of headline inflation, a figure that looks set to rise in the next few months. In order for imported inflation to cause domestic inflation to top 10% during this period, it would have to rise high enough to account for nearly half of headline inflation. But there are other items that could also cause inflation to rise more in the next few months than we have forecast. Chief among them is imputed rent.

It is extremely important for developments in the CPI – and one of the key assumptions underlying our long-term forecast – that house price inflation should begin to ease soon, thereby offsetting imported inflation. In spite of all the clouds on the horizon, we remain relatively optimistic about bringing inflation under wraps, and we expect it to subside rather quickly in 2023. According to our forecast, inflation will average 7% in 2022, 4.4% in 2023, and 2.9% in 2024.

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