House prices soaring in regional Iceland

In keeping with the recent pattern, the housing component weighed heavily in this month’s rise in the CPI. Imputed rent, which is derived largely from house prices, rose by 2.3% (0.43% CPI effect) and has now risen by more than 10% in 2022 to date.

House prices overall increased by 2.6% MoM, according to SI data. The MoM rise was largest in regional Iceland (3.4%), as in recent months, and smallest for detached housing in the capital area (1.7%). The price of capital area condominium housing more or less split the difference, increasing by 2.6% MoM.

In the past twelve months, house prices nationwide have risen by 20.1%, the fastest pace since autumn 2017. For the first time since mid-2020, when the current surge in house prices began, property in regional Iceland is now rising fastest. The YoY increase in house prices outside greater Reykjavík now measures 20.8%, followed by multi-family homes (20%) and single-family homes (19.7%) in the capital area.

Prices look set to keep rising with no end in sight, and we expect them to keep climbing in coming months, or until supply shortages are addressed. With higher interest rates and increased supply, the housing market will ultimately cool down.

Imported goods prices on the rise

Chief among other components weighing heavily in the May rise in the CPI were food and beverages and travel and transit. Food and beverage prices rose 0.92% MoM (0.14% CPI effect), owing to a broad-based increase, although grains, meat, and dairy products stood out from the rest. In the travel and transit component, new motor vehicles rose in price by 2.1% (0.11%) and petrol 2.9% (0.10%).

This was offset, however, by a 5.4% decline in airfares (-0.11% CPI effect), which was in line with our forecast. The dip in airfares accords with the seasonal pattern and comes on the heels of a nearly 22% surge in April, some of which was a temporary spike stemming from the Easter holidays.

Other upward-pushing items included hotel and restaurant services, up 1.35% (0.07% CPI effect), and recreation and culture, up 0.24% (0.02%).

Downward-pushing items included clothing and footwear (-0.03% CPI effect) and other goods and services (-0.03% CPI effect), the latter item due to a drop in insurance prices.

Stubbornly high inflation still on the horizon

As the chart below indicates, the housing component is the main driver of headline inflation, although imported inflation has gained steam recently and looks set to continue rising. In addition, higher imported prices will probably push domestic goods prices upwards over time. Of the 7.6% headline inflation figure for this month, 3.2% stems from housing, 1.8% from imported goods, 1.5% from services, and 1.1% from domestic goods.

The outlook is for imported inflation and house prices to keep rising in coming months, pushing headline inflation still higher, if our forecast materialises. In our short-term forecast, we project that the CPI will rise by 0.7% in June, and 0.4% in July, and 0.6% in August, pushing headline inflation up to 8.4% by August. We expect inflation to peak around that time and then start to subside – very slowly at first, and then at an accelerated pace after mid-2023.

It goes without saying that the inflation outlook is exceedingly uncertain at present; for instance, it is enormously difficult to predict how long foreign inflation will remain high and how much the ISK will strengthen to compensate. We think the ISK still has some untapped upside potential this year.

The main assumption underlying our long-term forecast is that house price inflation will begin to ease later in 2022. Another important assumption behind our forecast is that the wage negotiations set for late this year will not result in excessive pay rises. According to our forecast, inflation will average 7.6% in 2022, 5.9% in 2023, and 3.9% in 2024.