The ISK depreciated slightly in 2022. Intrayear exchange rate movements fell into two phases, however, with a strong appreciation through May, followed by a slide lasting until January 2023.
We forecast a modest appreciation of the ISK in the coming term
The ISK exchange rate has been relatively stable year-to-date in comparison with the past three years. The outlook is for a modest appreciation in the coming term, in tandem with an improving current account balance. We forecast therefore that on average, the ISK will be approximately 8% stronger in trade-weighted terms two years from now.
In 2023 to date, the ISK has been broadly stable relative to the three years beforehand, as the pandemic, the war in Ukraine, and other factors have caused considerable volatility since the start of the decade. The euro has fluctuated in the ISK 148-157 range and the US dollar in the ISK 135-145 range thus far in 2023. As of this writing, one euro costs just under ISK 151 and one US dollar costs 141, putting the ISK in the middle of the above-specified ranges.
Favourable underlying factors support the ISK
Near-term prospects for the current account have improved marginally relative to our February forecast. The outlook is for the deficit to close and a current account surplus to open up in coming years, although it will probably be a small one. The interest rate differential with abroad is relatively wide, Iceland’s external position is strong, and the stock of foreign-owned securities is low in historical and international context.
On the other hand, the pension funds will continue to allocate a sizeable share of their net inflows to foreign asset purchases, and other domestic entities are likely to scale up their foreign securities holdings as the global market outlook improves.
Our new macroeconomic forecast includes an exchange rate forecast for the next few years. The scope and timing of exchange rate movements is always highly uncertain, but we forecast that the ISK will be approximately 8% stronger at the end of the forecast horizon than at year-end 2022. This would give an exchange rate of roughly ISK 142 per euro and ISK 132 per US dollar.
The real exchange rate in terms of relative consumer prices will then be close to its 2017-2018 peak. It is possible that the ISK will rise temporarily above the forecasted level. In the end, the current account balance will pull it back into line, however, as Iceland’s competitive position will deteriorate and demand will shift increasingly out of the local economy.
In other words, Iceland could become In broad terms more expensive for the rest of the world, and foreign goods and services would become cheaper for Icelanders than is sustainable in the long run, as was the overriding pattern during the lead-up to the 2008 financial crisis .