As before, the October measurement is at the upper end of the range of published forecasts. Earlier in the month, we had projected that the CPI would rise by 0.2%. The food and beverages component rose considerably more than expected, increasing by 1.0% in October, its biggest jump since May. Presumably, the depreciation has begun to affect food prices to a greater degree, as the ISK has not regained ground after weakening in late summer. Petrol prices fell slightly between months, after fluctuating markedly at the start of the year and then stabilising for a few months. Imputed rent rose more than we had estimated, another sign of the resilience of the real estate market amid historically low interest rates.

What is interesting, though, is that over the past three months, various different items have contributed most to the monthly increase. Clothing and footwear rose most in August, followed by furniture and housewares in September and food and beverages in October. Twelve-month inflation according to the CPI excluding housing measures 4.1%, which means that the housing component is still pushing inflation downwards as of October

Food prices the main driver of inflation

The chief difference between our forecast and Statistics Iceland’s (SI) October measurement lies in our underestimation of the jump in food prices, discussed above. The housing, heat, and electricity component also rose noticeably in October, by a combined 0.4% month-on-month (0.12% CPI effect). There was also a slight MoM uptick in the travel and transport component, which includes motor vehicle prices, operation, and maintenance, as well as transport by road, air, and sea (0.03% CPI effect). Clothing and footwear have also continued to rise considerably (0.05% CPI effect), although the pace has eased a bit. It will be interesting to follow developments in the clothing/footwear component in December, when demand tends to be greater than in other months.

Composition of inflation radically changed year-to-date

Headline inflation has risen from 1,7% to 3.6% since the beginning of the year. As the chart indicates, the lion’s share of the inflation surge is due to the weakening of the ISK. Since the turn of the year, the ISK has fallen by an average of about 15% against other currencies, which inevitably affects imported goods prices. Of the current inflation rate, 2.2% – or nearly two-thirds – can be attributed to rising imported goods prices (excluding petrol) over the past twelve months. In comparison, imported goods contributed 0.2% to inflation in December, accounting for only one-tenth of overall inflationary pressures. Rising domestic goods prices account for 0.8% of the current inflation rate, but imported inputs often contribute significantly to the cost of domestic production.

Another interesting angle is the contribution of the housing component to inflation, which has held quite stable in 2020 to date, measuring 0.7% at the turn of the year and 0.5% in October. This reflects in large part how stable the housing market has been overall, in spite of the headwinds facing the economy this year.

Declining mortgage lending rates have played a major part in the role of housing in inflation, with two competing factors pulling against one another: On the one hand, lower mortgage rates have lowered imputed rent considerably, as can be seen in the 7% year-on-year rise in house prices according to the October CPI measurement, juxtaposed with a 2.2% rise in imputed rent. The interest component of imputed rent therefore offset more than half of the impact of rising house prices during the period. On the other hand, lower mortgage lending rates probably play a leading role in pushing house prices upwards despite the COVID crisis. As a result, it is unclear what impact of falling interest rates ultimately have on inflation.

Housing market retains its resilience

Imputed rent rose markedly between months, reflecting the buoyancy of the housing market in spite of the highest unemployment rate Iceland has seen in over a decade. House prices weigh heavily in the increase. Some 0.09% of the October rise in the CPI was due to imputed rent, which is a composite component that includes house prices and the effects of mortgage interest. As is discussed above, the interest rate portion has pulled strongly against the rise in house prices, thus dampening the rise in imputed rent.

Inflation above target in 2021

Developments further ahead are highly uncertain, but the autumn COVID wave has put a heavy burden on most countries worldwide. As yet, though, the Icelandic economy is on a sound footing. But a great deal depends on the tourism industry, and on when the pandemic begins to recede in earnest.