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.