Scenarios highlight uncertainties in the economic outlook

The path of the COVID-19 pandemic, Russia’s invasion of Ukraine, and the results of wage negotiations are among key uncertainties that, in coming months, could affect economic developments over the medium term. The alternative scenarios in our macroeconomic forecast examine the impact of these uncertainties and hopefully shed light on how strongly they could affect the Icelandic economy over the next three years.

The economic outlook for Iceland, like the global outlook, has fluctuated widely since we issued our macroeconomic forecast in January. In particular, developments in the COVID-19 pandemic and Russia’s invasion of Ukraine have changed the outlook in the interim. Furthermore, there is considerable uncertainty about the results of private sector wage negotiations later this year. Domestic economic developments in the coming term will be affected in no small part by whether or not wage settlements entail a smooth landing featuring wage rises in line with moderate inflation. Circumstances at the time the wage negotiations begin in earnest will also depend not least on the aforementioned two factors.

Although our recently published macroeconomic forecast depicts the path we consider likeliest in the coming term, the aforementioned factors, all of which will presumably be clarified in the next few quarters, will have a major impact on developments in 2022 and the years to follow. Because of this, we decided to supplement our baseline forecast, which we consider both the likely outcome and a balanced representation lying between optimism and pessimism about developments further ahead, with two alternative scenarios:

  • An optimistic scenario, which we consider to have a roughly 10% probability of materialising or being exceeded
  • A pessimistic scenario, which we consider to have a roughly 10% probability of materialising or being exceeded

The two alternative scenarios reflect developments that we consider realistic but much less likely to materialise than those in the baseline forecast.

This is a subjective assessment and not a statistical one, and it should be borne in mind that the interactions among the factors involved – pandemic, war, and wage settlements – could develop differently than is described here; for instance, some could develop more favourably, while others could more closely resemble the pessimistic scenario.

It should be noted that the scenarios, particularly the pessimistic one, are not conceived as stress scenarios. It is possible to sketch out an even more unfavourable path than is done here, but by the same token, such a scenario is less likely to materialise. The scenarios are intended to create a framework around the developments that we consider most likely to occur during the forecast horizon. In broad terms, we consider there to be an 80% probability that actual events will be neither worse than the pessimistic scenario nor more favourable than the optimistic scenario.

GDP growth could vary greatly over the forecast horizon, depending on how these key variables develop. For instance, GDP growth could turn out 2% weaker than in the baseline if these three variables develop unfavourably in coming months. Conversely, if the same three variables develop as is described in the optimistic scenario, GDP growth could prove 1.3% stronger during the forecast horizon. Reduced activity in the economy would then be reflected in higher unemployment further ahead, while stronger economic activity would cause unemployment to decline more rapidly than in the baseline.

In particular, developments in these uncertainties will affect Iceland’s export sector, especially the tourism industry, which is one of the mainstays of GDP growth in 2022 and will also contribute strongly to growth in coming years, according to our forecast. We estimate that tourist visits to Iceland could range from 1.15 million to 1.7 million in 2022, based on the two scenarios, and that by 2024 they could range from 1.7 million to 2.3 million, given the same assumptions. Iceland’s export revenues and the ISK exchange rate could therefore develop quite differently, depending on how these three variables evolve.

Under the pessimistic scenario, the ISK could weaken markedly again this year and not return to its current level until two years from now. If the more optimistic scenario materialises, however, the ISK will presumably appreciate more rapidly and rise to a higher level further ahead.

Various developments in the ISK exchange rate, the global price level, Icelandic wages, and Icelandic house prices will ultimately result in different inflation scenarios, depending on whether the Ukraine war, the pandemic, and private sector wage negotiations develop favourably or unfavourably. More favourable developments would lead to much faster disinflation and could bring inflation back to the Central Bank’s (CBI) target around mid-2023. On the other hand, an unfavourable outcome would fan the flames of inflation in the short run, although weaker economic activity, higher unemployment, and an appreciation of the ISK would ultimately cool inflation off.

As can be seen, there is much at stake for the Icelandic economy in seeing these uncertainties evolve in a positive direction. Naturally, we have little impact on how the pandemic or Russia’s war with Ukraine plays out, but wage negotiations are firmly in the hands of the social partners. We hope that, at the very least, the outcome will not exacerbate instability and cause tumult above and beyond what external developments may bring.


Jón Bjarki Bentsson

Chief economist