The interplay between wages and inflation

Although inflation has fallen swiftly in recent months, it remains well above the Central Bank’s (CBI) inflation target. One of the biggest uncertainties about the long-term inflation outlook is the outcome of wage negotiations. Below is a brief scenario analysis showing how inflation is likely to evolve in the next few years if wages develop more favourably or less favourably than in the ÍSB Research forecast. It is clearly to the benefit of all – households and businesses alike – to bring inflation down, thereby paving the way for lower interest rates.

The January CPI measurement brought glad post-holiday tidings: the index fell month-on-month, and headline inflation tumbled from 7.7% to 6.7%. Inflation looks set to keep falling fairly quickly in coming months, as months featuring hefty increases in H1/2023 are dropping out of twelve-month CPI measurements. The outlook is for the CPI to rise considerably less in the next few months and for headline inflation to fall. To give this some context, the CPI rose by nearly 1% per month in the first half of 2023; however, we project that it will rise by an average of 0.4% per month in H1/2024. If this forecast is borne out, inflation could be about 5% by mid-year.

Is target-level inflation a distant dream?

Even though inflation could subside fairly quickly in coming months, the CBI’s inflation target is still a far-off prospect. ÍSB Research’s new macroeconomic forecast, published at the end of January, contains a new inflation forecast as well. In that forecast, we do not assume that inflation will realign with the 2.5% during the current forecast horizon, which extends through end-2026. We project that it will average 5.2% this year, 3.2% in 2025, and 3.0% in 2026. That puts it very close to the target in the final year of the horizon.

One of the biggest question marks in the long run is wage agreements. If pay rises are excessive, there is a significant risk of a wage-price spiral. On average, wages have risen considerably in recent years, or by 7% per year since 2010. The smallest annual increase was 5% and the largest 11%.

Nominal wages rose 9.8% in 2023, and real wages grew by 1% despite high inflation. The increase was due to new wage agreements covering the entire labour market. The contracts had a term of only one year; thus a new round of negotiations is already underway. The situation is highly uncertain, of course, but we project that wages will rise by 6.5% this year, 5.5% in 2025, and 4.5% in 2026.

Wage-price spiral

Because wages are such a big uncertainty at present, our inflation forecast includes two alternative scenarios showing how the inflation outlook could change if wages rise more than in the baseline or less than in the baseline. Other variables in the inflation forecast are held constant. The scenarios are highly simplified, of course, and a range of other factors will affect inflation in the next few years, including the ISK exchange rate and real estate prices. However, the scenarios – one optimistic and the other pessimistic – look past these other factors and focus solely on wages

In the optimistic scenario, wages rise less than in our baseline forecast, or by 5% in 2024, 3.6% in 2025, and 3.1% in 2026. This scenario is all but Panglossian as regards domestic cost pressures, as it provides for pay hikes far smaller than those seen in the past several years. In the pessimistic scenario, wages rise by 9.5% in 2024 (virtually the same as in 2023), 9% in 2025, and 5.1% in 2026. In our opinion, this scenario is truly bleak, as it provides for generous wage increases extending over a two-year period, as well as assuming that wage agreements will trigger wage drift in the labour market.

As the chart below indicates, inflation will fall much more slowly over the forecast horizon if wages rise more instead of less. For example, the price level will rise by 12% over the next three years in the pessimistic example and by 8% in the optimistic one. On the other hand, our macroeconomic forecast provides for a 10% increase over the period. If the optimistic scenario materialises, inflation will reach the CBI’s target in mid-2026.

Monetary easing depends on inflation

The CBI kept the policy rate unchanged last week, and the tone in the Monetary Policy Committee (MPC) statement was considerably more accommodative than in November. We therefore think it most likely that the tightening episode is over and that the policy rate will be unchanged until the spring, provided that inflation continues to develop in line with forecasts. It is not impossible, though, that the MPC might decide to lower the policy rate as soon as next month. The monetary easing process will start gradually, and the policy rate will remain high in coming quarters. We project that the policy rate will down to 8.0% by end-2024 and 6% at the end of 2025, reaching 5% as the forecast horizon draws to a close.

But the margin for error is slim: unless everything falls fairly neatly into line, interest rate cuts could be even longer in coming; furthermore, the possibility of additional rate hikes in coming quarters cannot be ruled out. For instance, if the pessimistic scenario described above is borne out, the policy rate could be more than 1 percentage point higher, on average, over the forecast horizon. Conversely, if the optimistic scenario materialises, average interest rates could be more than 1 percentage point lower than in the baseline forecast. It is clearly of great benefit to all – households and businesses alike – to bring inflation down, thereby opening the door to lower interest rates.


Bergthora Baldursdottir