Economic review

After a buoyant period of strong GDP growth, the Icelandic economy has entered an adjustment phase

Fortunately, many of the pillars of the economy are quite robust at present, and it appears that the adjustment will be relatively painless and that living conditions for most will remain among the best in the world.


It is safe to say that the past decade has been bountiful for the Icelandic economy. After the severe shocks of the late 2000s, living standards are back to pre-crash levels or above them. The main driver of the upsurge is Iceland’s third resource — its uniqueness and clean wilderness — which, coupled with its fishing waters and renewable energy resources, provide the bulk of the country’s export revenues. In addition, efforts to resolve legacy issues from the financial crisis have been successful, and economic policy has supported a favourable outcome. Setbacks in the tourism industry early in 2019 marked a turning point in the economy, however, ushering in an adjustment after a period of booming growth. Output growth in 2019 as a whole is estimated at 0.3%, with a sharp contraction in business investment and services exports acting as a counterweight to consumption growth and a strong contraction in imports.

External trade remains favourable

The balance on combined goods and services trade showed a sizeable surplus in 2019, despite reduced tourist numbers and the failure of the capelin catch. Actually, the goods account deficit was the smallest since 2015, owing to a marked contraction in imports and more positive developments in exports than had been anticipated. By the same token, developments in services trade were more favourable than expected. In spite of severe blows to export sectors in 2019, the current account surplus for the year is likely to turn out relatively large, at just over 4% of GDP. Investment lost pace in 2019, after a five year period of uninterrupted growth. Residential investment retained its momentum, albeit outweighed by the contraction in business investment and public investment. Strong growth in residential investment has steadily increased the supply of new homes, helping to rebalance the real estate market. In greater Reykjavík, property prices rose by 2.3% in 2019, the slowest pace since 2011. Last year saw an abrupt turnaround in the labour market. Unemployment rose by about a percentage point of the labour force, and wage increases were the smallest since 2010. WOW Air’s collapse and the contraction in tourism were important factors in this about-face, together with streamlining in the banking system and elsewhere. This trend towards more sluggish real wage growth and rising unemployment is one of the main reasons for relatively weak private consumption growth in 2019.

ISK stable, inflation on the wane

After depreciating by 9% in H2/2018, the ISK was more stable by various measures in 2019 than in any single year since it was floated at the turn of the century. Economic headwinds had relatively little impact on the exchange rate last year. Furthermore, inflation fell significantly. By the end of 2019, it measured 2.0%, its lowest in two years. Over the course of 2019, the Central Bank lowered the policy rate by a total of 1.5 percentage points as the inflation outlook improved and the economy cooled. This brought the policy rate to its lowest since the inflation target was adopted in spring 2001.

Further adjustment ahead in 2020

For 2020, GDP growth is projected at a relatively slow 1.4%. Growth will be driven by a modest increase in domestic demand, whereas the outlook is for very sluggish export growth. Despite this, there is a strong probability that the current account will again show a sizeable surplus. The outlook is for a rebound in investment this year, owing mainly to growth in business investment after a two-year contraction. Also in the offing is an upturn in public investment, albeit offset by a significant slowdown in residential investment. The outlook is for house prices to rise broadly in line with the general price level.

Even though the signing of the standard of living agreement was positive overall, there is still some uncertainty in the labour market. This, together with rising unemployment, will prompt households to exercise greater caution this year, dampening private consumption growth. It appears that the ISK exchange rate is currently within the range that is consistent with an internally and externally balanced economy. It is quite likely to remain around the level seen in the past year, provided that there are no dramatic and unexpected changes in major underlying factors.

The outlook is for inflation to remain below the Central Bank target this year, averaging about 2.2%. Moderate inflation and the overall cooling of the economy will presumably lead to a low base interest rate level in 2020, and it appears that, on average, long-term rates will be at their lowest since interest rates were liberalised over 30 years ago. Although 2020 will be a challenging year economically, many of the pillars of the domestic economy are quite robust at present, not least because of improvements in household, corporate, and public sector debt. Therefore, for most segments of the economy, the outlook is for a relatively soft landing after the strong upswing of the last decade.