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Inflation winter spike more persistent than hoped

Rising petrol prices and house prices and end-of-sale effects explain most of increase in the CPI in March. Inflation has proven more persistent than expected this winter, but the outlook is for it to fall rapidly as the year progresses and align with the Central Bank’s (CBI) 2.5% inflation target around the year-end.

According to newly published figures from Statistics Iceland (SI), the CPI rose 0.49% month-on-month in March, raising headline inflation to 4.3%, from 4.2% in February. Inflation excluding housing measured 4.8% during the month. Thus the housing component tends to dampen inflation these days, despite the hefty rise in house prices in the past year.

The March measurement is at the high end of published forecasts. We had projected that the CPI would rise 0.4% between months. Key items that took us by surprise included the housing component, which rose markedly between months, primarily because of a steep rise in imputed rent, whereas we had assumed that lower interest rates would offset the rise in house prices. On the other hand, end-of-sale effects were weaker than we had anticipated.

House prices and fuel prices contribute to CPI rise

The housing component was the main driver of the CPI increase in March. The component as a whole rose by 0.6% (0.18% CPI effect), owing mainly to a 1.3% MoM rise in house prices. Imputed rent, which reflects the above-mentioned house price measurement plus the impact of mortgage interest expense, rose by 0.9% MoM (0.15% CPI effect). The mortgage interest component lowered imputed rent by 0.4%, due to the recent plunge in mortgage lending rates.

House prices are still rising steadily, led by single-family homes in the capital area (up 11.6%), while capital area condominium prices have risen by 8.7% and house prices in regional Iceland by 5.7% over the same period. In all, the rise in house prices nationwide now measures 8.5%, and a steady upward trend can be seen in SI data from autumn 2019 onwards. We attribute this to favourable mortgage rates, of course, but also to the limited supply of new housing and to most households’ robust financial position despite the Corona Crisis.

Apart from the housing component, petrol prices were the strongest driver of the March CPI increase. The price of gasoline and diesel fuel rose 4.0% MoM, the largest single-month increase in six years. Since November, petrol prices in Iceland have risen by nearly 11%. Over the same period, global crude oil prices have risen more than 50%, so the explanation for the domestic price hikes is ready to hand. Moreover, the effects have probably not come fully to the fore, although fortunately, global petrol prices have fallen somewhat in recent weeks.

End-of-sale effects pushed the CPI upwards quite a bit in March, albeit less than we had expected. The sales held at the beginning of the year seemed shallower than usual. Clothing and footwear prices rose 2.4% between months (0.08% CPI effect). On the other hand, furniture and housewares prices fell slightly, and most sales on these items were probably over by the time the February measurement was taken.

Although petrol and house prices were the main upward-pushing items in terms of the MoM rise, twelve-month figures tell a different story. Just about half of the current 4.3% headline inflation stems from higher prices on imported goods other than petrol. About 16% of inflation derives from domestic goods prices, a scant 14% from the housing component, and just over 18% from services prices. Petrol accounts for slightly less than 5% of the overall rise in prices in the last twelve months. This breakdown reflects the fact that the vast majority of domestic inflation originates in the depreciation of the ISK in Q2 and Q3/2020.

Benign medium term inflation outlook despite spike

Although inflation has proven more persistent this winter and the inflation curve steeper than we had expected, the outlook is still for a rapid decline over the course of this year. The exchange rate pass-through from the ISK depreciation has surfaced for the most part, and the appreciation of the past few months could start to affect inflation measurements soon. On the other hand, petrol prices could continue to be a thorn in the side of Iceland’s price level. The considerable slack in many segments of the economy and the probable appreciation of the ISK in H2 will help contain price increases later on, although steep cost increases – wages and housing in particular – will continue to push prices upwards in the quarters to come.

We expect the CPI to rise by 0.2% in April, 0.2% in May, and 0.3% in June, bringing headline inflation down below the 4% upper deviation threshold of the CBI’s inflation target by May and down to 3.6% by mid-year. Thereafter, we expect inflation to taper off still further. If our forecast materialises, it will fall back to the CBI’s 2.5% inflation target sometime around the turn of the year. As a result, the medium-term inflation outlook is quite good despite unsettling spikes in the recent past.


Jón Bjarki Bentsson

Chief economist