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Inflation to remain above the tolerance limit for a while to come

The outlook is for a 0.5% month-on-month rise in the CPI, bringing headline inflation to 4.5% in October, if our forecast materialises. House prices contribute the most to inflation at the moment, although imported inflation is making its presence felt as well. We expect inflation to hold close to the upper tolerance limit of the Central Bank’s (CBI) inflation target for a while to come and then start to ease after the turn of the year. If our forecast materialises, it will align with the 2.5% target in Q4/2022.

We project that the consumer price index (CPI) will rise by 0.5% month-on-month in October, and that twelve-month inflation will measure 4.5%, up from 4.4% in September. We expect inflation to rise slightly in coming months before starting to ease gradually at the beginning of 2022. House prices and imported inflation are the main reasons inflation has been so persistent. We expect inflation to align with the Central Bank’s (CBI) target in Q4/2022. Statistics Iceland (SI) is scheduled to publish the CPI for the month on 27 October.

House prices a major driver of headline inflation

As in recent months, house prices are the main driver of the rise in the CPI in October. Imputed rent has been the leading contributor to inflation in the past several months, rising by more than 9% since March. According to our measurement, the same pattern will show in October. We expect imputed rent to rise by 1.1% month-on-month (0.18% CPI effect).

In the past twelve months, house prices nationwide have risen by 14.7%, the fastest pace since year-end 2017. The imputed rent component of the CPI is based on home purchase agreements over a three-month period, so the October measurement will cover agreements made in July through September. According to our house price measurement, the CBI’s policy rate hike in late August has not yet made a discernible impact on property prices.

There are various signs of overheating in the housing market at present, and the CBI has stated that in order to bring inflation down, the housing market must be cooled off. The bank has begun to take the reins on that score, with policy rate hikes and other measures. At the end of September, the CBI’s Financial Stability Committee (FSN) introduced 35% a cap on debt service-to-income (DSTI) ratios for all but first-time buyers, after having decided in late June to lower maximum loan-to-value (LTV) ratios from 85% to 80% – again, for all but first-time buyers. These two actions could ease the worst of the inflationary pressures relatively quickly, so it will be interesting to keep abreast of market developments in coming months.

Other upward-pushing CPI items

Apart from the housing component, we expect travel and transport (0.19% CPI effect) to have the strongest upward-pushing impact in October. One of the main contributors here is petrol prices, which are up by a full 14% year-to-date and will rise by 3.8% between September and October (0.12% CPI effect), according to our forecast. Global fuel prices have skyrocketed this year, affecting prices at petrol pumps in Iceland and elsewhere. For instance, Brent crude was selling at just under USD 52 per barrel at the beginning of the year but has risen to nearly USD 83 as of this writing, a jump of almost 57%.

We also expect airfares to rise by 3.2% MoM (0.05% CPI effect). In the past two months, airfares have fallen, most likely because of the Delta wave of the COVID-19 pandemic. But appetite for travel appears to be on the rebound by now, and we expect a steady rise in prices in coming months. Rising oil prices are also a factor in airfares, of course.

Other items set to rise in price between months are food and beverages (up 0.3%, CPI effect 0.4%), furniture and housewares (up 0.4%, 0.03% CPI effect), and health (up 0.4%, CPI effect 0.02%), as pharmaceuticals prices have risen, largely due to the depreciation of the króna.

Inflation to start falling in early 2022

The outlook is for inflation to remain above 4.0%, the upper deviation threshold of the CBI’s inflation target, for a while to come. According to our preliminary forecast, the CPI will rise by 0.3% in November and 0.4% in December, and then fall by 0.2% in January. If this forecast is borne out, twelve-month inflation will measure 4.7% in January. Thereafter, we expect it to fall below the CBI’s upper tolerance limit relatively quickly and then align with the 2.5% inflation target in Q4/2022. According to our forecast, inflation will average 3.3% in 2022 and 2.6% in 2023.

This forecast is based on the assumption that the ISK will appreciate in coming quarters, and as we have mentioned numerous times, we think the ISK has some upside potential and will gain strength as tourist numbers pick up. On the other hand, house prices seem more or less unbridled at the moment, which could cause inflation to be higher and more persistent than we assume in our forecast. ÍSB Research is convinced that the CBI will continue to take targeted action to cool off the housing market until it reaches some sort of equilibrium. An increased supply of housing should also help further ahead.

But we are also quite concerned about imported inflation at the moment. Because of the pandemic, the price of a number of goods has soared, as have shipping costs. Steep price hikes abroad will push imported goods prices upwards even if the ISK appreciates, and if those price hikes continue, imported inflation could cause domestic headline inflation to be more persistent than we have assumed here.


Bergthora Baldursdottir




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