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Inflation set to ease in August

The outlook is for the CPI to rise by 0.4% month-on-month in August. If this forecast materialises, headline inflation will measure 4.2% during the month, its lowest since February. The main contributors to the August uptick in the CPI are house prices and end-of-sale effects. Domestic cost pressures are the main driver of inflation, as exchange rate pass-through from the depreciation of the ISK has subsided steadily.

We project that the consumer price index (CPI) will rise by 0.4% in August. If our forecast is borne out, twelve-month inflation will taper off marginally, to 4.2%. The short-term inflation outlook has improved slightly, in our opinion, and it appears that the peak of the current inflationary episode is behind us. As before, though, inflation does not appear likely to align with the Central Bank’s (CBI) inflation target until after mid-2022. Statistics Iceland (SI) will publish the August CPI measurement on 30 August.

End-of-sale effects weaker than usual

As is common in August, end-of-sale effects are expected to exert a considerable upward impact on the CPI. Even so, we expect that impact to be much less pronounced than in recent years. The effects of summer sales turned out weaker than usual in July – apart from last year, that is. This is probably due to a combination of shallower sales and different timing of sales, both of which are reflected in our CPI forecast for August and September. Unlike last year, however, clothing, electronics, and housewares stores are probably able to buy new inventory at a more favourable exchange rate than was on offer when they bought sale items earlier this year. Taken together, these items will probably raise Q3 inflation less sharply than in 2020, although domestic costs have risen in the interim.

We project that clothing and footwear prices will push the CPI upwards by 0.15% in August. Apparently, though, sales held by many large electronics and housewares stores extended into the August measurement period, so we expect the price cuts on these items to lower the CPI by 0.03% this month.

House prices continue to push upwards

Apart from clothing and footwear, imputed rent is the main upward-pushing item (0.10% CPI effect) in our forecast for August. House prices are still climbing steadily all over the country, rising 13% year-on-year in July, according to SI figures. House prices are the main determinant of imputed rent, and we expect them to rise by 0.6% MoM in the August measurement, well below the average MoM increase of 1.25% in 2021 to date, according to SI data.

Other items that are expected to raise the CPI in August include petrol, which is set to rise by just over 1%, according to our survey (0.03% CPI effect). Furthermore, imported input prices will raise home maintenance costs by 0.5% (0.03% CPI effect), while food and restaurant services will raise the CPI by 0.02% and 0.01%, respectively. Developments in airfares are quite uncertain at present, as the ground is constantly shifting under the feet of the airline market these days and we do not expect the air transport component to raise or lower the CPI in August.

Domestic inflationary pressures take over from imported pressures

The composition of inflation has changed markedly since the current inflationary episode began in the wake of the COVID-19 pandemic last year. Early on, the depreciation of the ISK was the main driver of inflation, but by June, the situation had changed significantly. Of the 4.3% inflation measured in July, 1.2% was due to imported goods, 1.5% to the housing component, 1.2% to domestic services, and 0.4% to domestic goods. Although imported inputs certainly account for a share of the cost of most domestic items, it can be concluded that domestic cost factors and developments in asset prices are the main drivers of inflation at present.

 Inflation set to ease over time

The outlook is for inflation to remain close to 4.0%, the upper deviation threshold of the CBI’s inflation target, for a while to come. We forecast that the CPI will rise by 0.4% in September, 0.2% in October, and another 0.2% in November. If this forecast materialises, headline inflation will measure 4.2% in November. It looks set to measure 4.1% by the year-end and decline steadily thereafter. We project that it will finally align with the CBI’s 2.5% target in Q3/2022 and then remain close to target from then on. According to our forecast, inflation will average 3.0% in 2022 and 2.6% in 2023.

It is worth noting that the current inflationary episode is not unique to Iceland at the moment. The pandemic’s effect on the price level has generally been to push consumer prices upwards this year, owing both to supply-side bottlenecks and to surging demand in many countries as the pandemic began to subside. Furthermore, real estate prices are widely on the rise, as they have been in Iceland, although in most cases the price hikes do not show in inflation measurements. But just as in our forecast for Iceland, the inflation spike is generally expected to be short-lived.

The table gives a summary of the key assumptions underlying our long-term forecast. We expect the ISK to strengthen by approximately 5% from now until the end of the forecast horizon, keeping imported inflation low. Conversely, we expect considerable domestic cost pressures. We estimate that wages will rise by an average of 4.5% per year over the next two years. We also expect a fairly robust real increase in house prices, although the pace of the rise will probably be much slower further ahead than it has been recently.

If the ISK appreciates more in coming quarters than we have forecast, inflation could subside faster than we anticipate. On the other hand, inflationary pressures from wages and/or house prices could turn out stronger than we assume, causing inflation to be more persistent in the coming term.


Jón Bjarki Bentsson

Chief economist