Economic summary

Iceland recorded strong GDP growth in 2022, driven by a surge in exports, buoyant private consumption, and robust growth in investment. Mounting demand pressures began to take root, however, as could be seen in a tight housing market, a sizeable current account deficit, and rising inflation. The outlook for 2023 is for modest growth in the domestic economy, and the adjustment towards equilibrium will probably feature an improvement in external trade, a better balanced labour market, and falling inflation.

2022

GDP growth was robust in 2021 and then gained significant steam in 2022. It measured 7.4% over the first nine months of the year and looks set to be around 7% for 2022 as a whole.

The swift growth seen in 2022 is due in large part to a surge in private consumption, which grew by about 10.9% in real terms over the first three quarters of the year. Private consumption growth was supported by the recovery of the labour market, the strong financial position enjoyed by most households, population growth, and a significant pent-up desire to travel after the restrictions of the pandemic era.

Investment growth was relatively robust as well, measuring more than 4% overall during the year. It was sustained by a surge in corporate and public investment, as residential investment probably contracted somewhat in 2022.

Exports also rebounded strongly, with growth estimated at nearly 23% for the year as a whole. On the other hand, the boom in domestic demand and exports called for a vast increase in imports, which are projected to have grown by almost a fifth.

Current account deficit wider than expected

The tourism industry played a key role in export growth, and prospects for the sector improved late last winter, after the relaxation of public health measures in Iceland and abroad. A total of roughly 1.7 million tourists visited Iceland in 2022, about the same as in 2016. Other sources of export growth included aquaculture, intellectual property and IT, and capelin products. Furthermore, exported goods prices fluctuated widely in 2022, not least aluminium prices, which spiked in 1H and then plunged commensurably in 2H.

On the imports side, there was a marked increase in imports of both goods and services. Imports of consumer goods and fuels skyrocketed, and imports of generic investment goods rose strongly as well. Moreover, Icelanders travelled abroad in large numbers, and in fact, frequent overseas trips were among the main drivers of year-on-year growth in services imports.

The current account deficit was significant last year, the second year in a row following a decade of near-constant surplus. A sizeable goods trade deficit and a considerable deficit on primary income were the main culprits, with a surplus on services trade as a mitigating factor. Iceland's international investment position deteriorated somewhat in 2022 but remains quite strong. External assets net of external liabilities equalled approximately one-fourth of GDP at the end of the year.

Labour market back on its feet after the pandemic

The labour market rebounded strongly in 2022. Over the course of the year, unemployment fell from 5.2% to 3.4%, more or less realigning with the pre-pandemic rate. In addition, the number of participants in temporary labour market initiatives declined sharply during the year, and the number of employed persons rose by over 7% relative to 2021.

Wage growth was generally strong in 2022, averaging about 8.3%. Pay rises were proportionally largest among lower-paid workers, as the wage agreements then in effect provided for unit-based increases. Most private sector wage agreements expired at the end of October, whereupon a large share of private sector workers made agreements that will remain in effect until January 2024. Lower-paid workers' real wages rose in 2022 despite high inflation, although higher-paid workers saw their real wages contract somewhat.

Surging inflation called for hefty policy rate hikes

The ISK averaged just over 3% stronger in trade-weighted terms in 2022 than in 2021. Developments within the year were split into two phases, however: The ISK strengthened markedly from the beginning of the year until early summer, only to fall markedly thereafter, ending the year nearly 3% weaker than it began it. The depreciation starting in early June was due to a wider-than-expected current account deficit, large-scale outward investment in foreign securities, unfavourable financing conditions abroad in 2H, and changes in expectations.

Inflation jumped from 5.7% to 9.6% over the course of the year, driven by the combined effects of surging imported goods prices following the war in Ukraine, the depreciation of the ISK in 2H, rapid house price inflation, and growing demand pressures within Iceland. It peaked at nearly 10% in July and then began to fall, albeit with a temporary uptick in December.

The Central Bank responded to the deteriorating inflation outlook and mounting demand pressures with steep policy rate increases, raising the key rate from 2.0% at the beginning of 2022 to 6.0% by the year-end. The policy rate hikes were reflected in rising real rates over the course of 2022. Long-term indexed Treasury bond yields, for instance, rose from approximately 0.5% to about 2.0% over this period. In the final months of the year, indicators finally started to suggest that this monetary tightening had begun to affect house prices and private consumption.

2023 looks set to be a year of adjustment for the Icelandic economy

For 2023, the outlook is for GDP growth to be much slower than in the recent term, at just over 3%. It will probably be driven mainly by export growth, as the contribution of consumption and investment will shrink markedly between years. Furthermore, the outlook is for import growth to slow markedly relative to previous years.

Increased activity in tourism will probably play a major role in export growth this year, as the outlook is for tourist arrivals to exceed 2 million for the first time since 2019. That said, it is highly uncertain whether – and how much – difficult economic conditions will deter European and American visitors from travelling to Iceland, although as yet there is little or no sign of a downturn in demand. Furthermore, the outlook is for growing exports of farmed fish, aluminium, and other industrial goods, as well as increased revenues from intellectual property exports.

A slower real wage growth, the impact from higher interest rates and a stable labour market are among the main reasons for a slower private consumption growth this year than in recent quarters. A healthy growth in residential housing investment coupled with moderate business investment growth will outweigh a contraction in public sector investment, resulting in modest total investment growth year-on-year. Higher interest rates and increasingly muted expectations about businesses' operating environment are among the factors that will dampen many firms' appetite and capacity for investment.

The wage agreements finalised for a large share of the private sector at the end of 2022 set the tone for this year's wage developments. The outlook is for wage growth to measure around 8% overall in 2023. Lower-income groups will receive proportionally larger pay rises than their higher-income counterparts, but the difference between them will be considerably smaller than in recent years, as provisions allow for a mixture of unit-based and percentage-based increases. The labour market looks set to be relatively tight early in the year, with unemployment likely to be average around 3%, broadly similar to the end-2022 rate.

The outlook is for the exchange rate to be below its 2022 average for a while to come. Further ahead, however, the chances of a stronger ISK will increase as the current account balance improves. For the current account, however, the outlook for 2023 as a whole is somewhat more ambiguous than previously anticipated.

A more stable ISK, a slower rise in imported goods prices, a better balanced housing market, and diminishing demand pressures will probably contribute to falling inflation in 2023. The Central Bank's tighter monetary stance will be a factor as well. Inflation looks set to average just over 7% during the year but fall to slightly over 6% by the year-end. There are still considerable domestic cost pressures in the offing, and these will be one of the main drivers of inflation further ahead. The policy interest rate is likely to rise somewhat over end-2022 levels early in 2023. In 2H, however, a slow monetary easing phase could ensue in late 2023, provided that inflation has begun to fall decisively.

Thus an adjustment period lies ahead for the Icelandic economy, although the economic and labour market outlook is brighter than in many neighbouring countries.