Some of the increase in inflation is temporary

This month’s CPI spike, which is unusually large relative to recent December measurements, can be said to stem from three factors:

• The November sales have grown larger in scope and longer in duration than in recent years. The positive impact of those sales on November inflation reversed as expected in December. For instance, clothing and footwear prices rose 3.6% (0.13% CPI effect), furniture and housewares prices rose by 2.3% (0.11%), and recreation and culture increased 0.46% (0.05%).
• Seasonal factors were unusually strong in December, particularly to include an outsized jump in airfares by 26.8%, far exceeding the typical December spike; and an abrupt 9.2% increase in indoor heating costs, which generally rise at the turn of the year. The latter of these was announced by Veitur in early December, when it adjusted its schedule of fees upwards to include a 7% rise in usage fees and a sizeable increase in fixed charges.
• The underlying upward pressure appears somewhat stronger at present than might have been assumed from November figures. Apart from the above two factors, however, underlying inflationary pressures are growing far less than it might appear at first glance.

The good news in SI’s numbers includes food and beverage prices, which fell 0.23% MoM (-0.04% CPI effect), owing mainly to a decline in the price of meat and fruit; and paid and imputed rent, both of which rose modestly in comparison with the average of recent months.

Underlying inflation ticks upwards … for now

Underlying inflation fell by all key measures in November, which surely came as a great relief to the CBI’s Monetary Policy Committee (MPC) after the 19 November policy rate cut. The respite proved only temporary, however, as all measures of underlying inflation rebounded with a will in December, as can be seen in the chart.

It should be borne in mind, however, that indoor heating and airfares are included in all of the above-mentioned core indices, and because they have risen so steeply now, the core indices can be expected to develop somewhat more favourably in the months to come.

What will the MPC do in February?

Our preliminary forecast for the months ahead is as follows:

• January: CPI to fall 0.3% (twelve-month inflation 4.5%) – Price list hikes for various services and unit-based increases in public levies offset seasonal sales and falling airfares.
• February: CPI to rise 0.7% (twelve-month inflation 4.2%) – End of seasonal sales for most key items.
• March: CPI to rise 0.3% (twelve-month inflation 4.2%) – lingering end-of-sale effects.

The short-term outlook for headline inflation has dimmed somewhat with the disappointing December measurement. Nevertheless, we expect airfares to fall correspondingly more in January, and the increase in utilities costs, part of the housing component, should be smaller after the December surge.

Bond yields thus far today indicate that market expectations about inflation and interest rates in the quarters ahead have changed since the end of last week. The yield on nominal Government bonds has risen by 7-15 basis points, and the yield on inflation-indexed Government bonds with a duration of three years or more has fallen by 2-13 basis points. In both cases, short-term yields have changed the most. Therefore, the market now expects inflation to be somewhat higher and upcoming policy rate reductions to be smaller than it did before the weekend.

The first policy rate decision of 2026 is scheduled for 4 February. The MPC will have its work cut out for it as tries to reconcile ever-clearer signs of economic headwinds against persistent inflation, which will probably be about the same in January as it was when the Committee decided to cut interest rates in November. The Committee’s task will not be made easier by the recently published measurements of household and corporate inflation expectations, which show that expectations over horizons of two years or more, which are well above the CBI’s 2.5% inflation target to start with, have remained unchanged between surveys. It should be borne in mind, though, that Q4/2025 inflation (4.2%) was marginally below the forecast in the CBI’s November Monetary Bulletin.

Whether or not the MPC will lower the policy rate in February is up in the air, but the probability of a rate cut is undeniably reduced after today’s inflation figures.