Real wages firm up again

Real wages have taken a turn for the better, buoyed by nominal pay rises in Q4/2022 and the more recent decline in inflation. The appreciation of the ISK since the mid-2010s is responsible for a substantial share of the past twelve years’ real wage growth. The prospect of sizeable nominal wage gains in the coming term is likely to keep inflation above the Central Bank’s (CBI) inflation target.

The wage index rose 1.1% month-on-month in June, according to new figures from Statistics Iceland (SI), probably due in large part to the public sector wage agreements finalised during the month. As measured by the general wage index, Icelanders’ wages have risen by an average of 4.9% year-to-date, but the increase over the past twelve months is considerably larger, or 10.9%, owing to the generous wage agreements landed by the vast majority of private sector workers late in 2022.

Year-on-year real wage growth has turned a corner in recent months. From June 2022 through May 2023, high inflation eroded YoY gains in real wages almost without interruption, apart from this past December, when the above-mentioned private sector pay hikes kicked in. Even so, the general wage index rose markedly over the period.

Now that the dust has more or less settled as regards this year’s wage agreements and inflation has started to ease, Icelanders’ paychecks are generally stretching a bit further at the cash register than they did a year ago. YoY real wage growth measured 1.9% in June, for instance.

Purchasing power better protected in Iceland than in many other countries

Although inflation has taken a chunk out of Icelanders’ wallets, wages here have picked up much more of the slack than in most neighbouring countries during the recent global inflation episode. In May, the CBI published an interesting comparison of real wage developments in Iceland and other countries over the past several years, which showed that even though purchasing power in Iceland retreated slightly in 2022, neighbouring countries on both sides of the Atlantic suffered far greater losses. From the onset of the pandemic in early 2020 until the end of 2022, real wages grew by an average of 2% per year in Iceland, while they contracted by an average of 1% per year in the rest of Europe and 0.3% in the US.

Booming real wage growth from 2010 onwards

In general, labour productivity, wage growth, and inflation should correlate over the long term. Real wages should therefore go broadly hand-in-hand with growth in value creation per hour worked, and the difference between the two should show in the domestic inflation rate. For example, the CBI has often said that pay rises should be more or less equal to the inflation target plus labour productivity, yet it has seldom been granted its wish, as wages have risen by an average of 7% per year since 2010.

Developments in these variables in the interim can be seen in the chart below. The CBI published an assessment of developments in labour productivity in the May issue of Monetary Bulletin, and Statistics Iceland’s (SI) assessment of labour productivity over the same period is available as well. Although the two institutions’ assessments differ for given years, the overall pattern is similar. Labour productivity grew by 0.9% per year according to SI, and by 0.7% according to the CBI. For our purposes, we use a simple average of the two, or 0.8% per year over the past twelve years. Real wage growth averaged 3.3% per year over the same period, however, indicating that workers can be reasonably satisfied with their lot.

These two variables have interacted in a range of different ways in the past dozen years, owing to a number of complicating factors. In 2014-2017, for instance, Icelandic workers enjoyed handsome wage gains, as inflation was by and large below the 2.5% inflation target and nominal pay rises were well in excess of the CBI’s informal benchmark increase of productivity growth plus the inflation target. The main contributor was the appreciation of the ISK, which measured over 30% from the beginning of 2014 through the end of 2016. Supplementing this was very low global inflation, which kept the price of imported goods and inputs in check, thereby offsetting domestic cost increases due to wage rises.

On the other hand, there appear to have been a few periods from 2010 onwards with a reasonably healthy balance between wage costs and inflationary pressures. The first four years of the 2010s were one such period, as were 2018 and 2019, and then the past two years. It goes without saying that 2020 was an outlier in this respect, with the pandemic and the policy responses to it strongly affecting hours worked and, as a result, affecting measured productivity as well.

In other words, it can be argued that the past twelve years’ real wage growth in excess of productivity growth stems mainly from favourable developments in the external balance of the economy, which delivered strong exchange rate gains. That trend, in turn, is due largely to the emergence of tourism as the third pillar of export revenues, alongside favourable global price developments and the successful settlements reached with the old banks’ creditors. Such a shot in the arm is hardly in the cards at present, though, and we therefore expect productivity and real wages to be better aligned in the coming term than they were in the mid-2010s.

Robust real wage growth in the coming term

In our most recent macroeconomic forecast, published in late May, we sketched out the wage/productivity scenario that we considered most likely for the near future. In that forecast, we projected that wages would rise by 9% this year, 8% in 2024, and 6% in 2025. On the flip side, we projected inflation at 8.7% this year, 5.3% in 2024, and 3.7% in 2025. If these predictions are borne out, real wages will rise by 0.3% in 2023, 2.6% in 2024, and 2.2% in 2025.

The decline in inflation according to our forecast is based to a large extent on the expectation of far more modest house price inflation, a moderate appreciation of the ISK, and greater price stability abroad in the coming term. But if our forecast materialises, cost pressures due to wage rises will be a more persistent driver of inflation in the near future and, indeed, will be the main reason inflation does not converge with the CBI’s inflation target in the latter half of the forecast horizon. That being the case, would be far better if the CBI’s wish list were granted and wage developments fell more closely into line with the inflation target than they have in the recent past. Such a turn of events would probably deliver similar real wage gains at a lower interest rate than would otherwise be needed.


Jón Bjarki Bentsson

Chief economist