The chart below shows the composition of inflation over the past two-and-a-half years. It indicates clearly that the cost of housing is by far and away the biggest cause of inflation, accounting for 1.72% of the current 4.2% headline figure. This means that at the moment, just over 40% of twelve-month inflation is due to housing costs. This ratio of housing costs to inflation has fallen since the new imputed rent calculation method was adopted a year ago; in fact, the last measurement using the old method showed that housing accounted for nearly half of headline inflation. Actually, the housing-to-inflation ratio rose just after the change was implemented, as summer 2023 declines in imputed rent dropped out of twelve-month measurements. Since the beginning of 2025, however, it has fallen markedly.

Services inflation

The second-largest contributor to twelve-month inflation is “other services”, which includes all kinds of services not provided by Government institutions. These services accounted for 0.91% of headline inflation in June 2025. Services prices are generally more stubborn than goods prices, as they are determined largely by wages, which are naturally stickier than, say, the global market price of other inputs, which can fluctuate widely. There are exceptions to this, though. Airfares, for instance, fluctuate with changing seasons, fuel prices, and exchange rate movements. As the chart above illustrates, the contribution of services to twelve-month inflation has actually fluctuated less than the contribution from domestic and imported goods. Collective bargaining agreements therefore have a strong impact on services inflation, but they also make it more predictable, especially when long-term contracts are reached, as was done in the last round of negotiations. The results of the most recent wage negotiations make it clear that services inflation will remain fairly persistent.

Goods inflation

Goods prices also depend on wage costs, but they are affected by energy and input prices as well. Goods prices skyrocketed during the pandemic, when supply chains were derailed and the ISK depreciated. Russia’s invasion of Ukraine brought on another wave of such price hikes, and for much the same reasons – snarled supply chains in particular. The Gordian supply chain knot has been cut since then, and goods price inflation has abated as a result.

The contribution of imported goods to inflation has eased thus far in 2025, owing to greater price stability abroad and a stronger ISK. Not so for domestic goods, whose share in headline inflation has risen by nearly 50% this year. In this case, the drivers are higher wage costs, which apparently have been passed through to prices more or less undiluted, and higher electricity costs for food manufacturing. Indeed, food price inflation has been this year’s biggest surprise. Supply chain disruptions are at work here, too: higher cocoa prices have caused the price of chocolate to surge, for instance.

In all, food and beverage prices are up 4.5%. Coffee, tea, and cocoa prices have risen the most, at 17%, due to the aforementioned supply chain disarray. These are followed by soft drinks, juices, and water (up 8%), meat (6%), candy (5.3%), milk, cheese, and eggs (4.4%), and fish (4.3%). We expect this burst of food price inflation to lose steam soon, and the effects of this year’s contractual pay increases have already come largely to the fore. Most contractual pay rises have already kicked in, and the wage scale supplement took effect in April. Furthermore, a supplement for public employees will take effect this coming September.

The contribution of imported goods excluding fuel has shrunk overall in 2025, although it picked up slightly between May and June, to the current 0.51%. If fuel is included, the same figure has fallen even farther, as fuel prices have generally declined this year, albeit less than the drop in global market prices would indicate. The appreciation of the ISK has therefore kept price hikes in check, both for imported goods and for inputs used in domestic goods manufacture. The contribution of domestic goods to inflation is somewhat higher, at 0.78% as of June, and has risen by more than 50% year-to-date.

Are housing costs the pivotal factor?

The change in methodology for calculating imputed rent has been an ongoing topic of discussion, as it touches on the largest single driver of inflation in the past few years. Until the change was implemented, there were concerns about its potential adverse effects on measured inflation. Those concerns centred mainly on the discrepancy that had developed between rent prices and house prices, with house prices rising far more than rent in the recent term. As a result, it had become more likely that rent would start to rise faster, therefore closing the gap that had opened up. If so, there would be two surges in housing costs in the CPI, solely because of the change in methodology. The chart below shows changes in the ratio of house prices to rent over the past several years.

A number of factors could prevent the gap between house prices and rent from closing soon, and even if it does close, it is unclear how quickly that will happen. We do not expect imputed rent to balloon in the near future, nor do we expect its contribution to headline inflation to shrink much. Intractable housing costs are one of the main reasons we do not expect inflation to realign with the target very soon, although it will certainly move closer. In other words, the contribution of housing to inflation would have to shrink significantly in order to return inflation to target quickly. While we do not rule this out, we consider it fairly unlikely. It can therefore be said that housing costs are the biggest hurdle in the dash towards target-level inflation.

Within tolerance limits but above target?

Although we do not expect inflation to converge upon the target in the near future, we do expect it to remain below the upper deviation threshold of the Central Bank’s (CBI) target in the years just ahead. The main reasons for our conclusion are wage rises and inelastic housing costs. The domestic economy is robust – stronger than previously thought, in fact. This is nothing new. Households’ saving rate is historically high, their debt position is good, and domestic demand has begun to pick up again. Households’ payment card turnover is growing apace, and motor vehicle purchases have rebounded in 2025. Iceland’s export sectors have large investment projects in the pipeline, although higher taxes and delays in energy procurement could put a spanner in the works. The labour market has cooled but is healthy and growing better balanced. Most indicators therefore support the conclusion that inflation will not make it all the way to target in the immediate future.