As the chart shows, many commodity prices had already jumped by the time the Russian invasion began. The price hikes stem in part from growing demand and production bottlenecks during the final lap of the COVID-19 pandemic, which had already begun to make their mark in H2/2021, but they also reflect increased Russian bellicosity during the prelude to the war, which pushed prices markedly higher during the weeks leading up to the invasion.

This will have multi-faceted effects in Iceland, as it will in other countries that are actively engaged in international trade.

The inflation outlook

All else being equal, higher energy and commodity prices will push inflation considerably higher in Iceland. According to Statistics Iceland (SI), imported goods account for about one-third of the CPI. Of these, petrol accounts for about 3% of the GDP, and imported food and beverages 3.4%. It should also be borne in mind that imported inputs carry considerable weight in other CPI components, including passenger transport and domestic foodstuffs. For example, the surge in wheat prices will have a broadly equal impact on the price of domestic bread and foreign baked goods.

Although imported items do not account for an overly large share of twelve-month inflation, as the chart shows, this situation is all but guaranteed to change rapidly. Presumably, the effects will show first in petrol and food prices and then spread to airfares and other travel-related expenses. In the end, they will affect most imported CPI subcomponents over a period of roughly 6-9 months. It is enormously uncertain, of course, how long-lasting the price hikes abroad will be and how much they could be offset by an appreciation of the ISK. These factors will be explored more fully in our inflation forecast, set for publication in the days to come.

External trade

The sudden spike in imported goods prices has a negative impact on the current account, all else being equal, as terms of trade (the purchasing power of export revenues vis-à-vis imports) will deteriorate accordingly. As a result, Iceland will have to export larger volumes or receive higher prices for exported goods and services in order to cover the cost of the same volume of imports.

Iceland’s largest export categories are energy-intensive industrial products and marine products, with values of ISK 308bn and ISK 326bn, respectively, in 2021. But this does not tell the whole story because the larger export revenue share deriving from marine products reflects more domestic value addition than is the case for industrial exports.

Part of the above-mentioned surge in commodity prices has been seen in a sharp rise in the price of aluminium. The reference price of aluminium is now just over USD 3,400 per tonne, an increase of 22% year-to-date. Actually, aluminium prices had already risen by over 40% in 2021, so domestic aluminium producers have benefited greatly.

Marine product prices have also picked up strongly in the past year and look quite likely to keep climbing.

In addition to this, exports will be disrupted, at least temporarily, marine product exports in particular. According to information from the Government Offices website, Iceland’s exports to Russia, Belarus, and Ukraine totalled ISK 20-25bn in 2021, or roughly 2% of total exports. The vast majority of them are pelagic fish such as capelin, herring, and mackerel, with 5% of total marine export values going to these three countries. Over time, though, exporters will probably find other markets for these products, just as they did in the wake of the Russian sanctions eight years ago.

It is still impossible to predict the effects of the Ukraine war on the tourism sector. According to recent news reports, there have been few cancellations by foreign tourists and the outlook is still for a substantial increase in tourist arrivals this year, but the war is all but certain to affect the situation. The surge in fuel prices will doubtless push airfares upwards in coming months, and Americans’ and Europeans’ appetite for travel may well diminish because of heightened uncertainty about the war and reduced purchasing power in the wake of spiking inflation abroad. On the other hand, it has been pointed out that Iceland is a safe destination, and one that has been shown to be very popular among COVID-weary travellers during lulls in the pandemic.

Overall, the war will probably have a negative impact on Iceland’s external trade and cut into trade-generated foreign exchange revenues in 2022. How strong that negative impact proves to be will depend, of course, on developments in the war.

Interest rates

The war in Ukraine has exacerbated uncertainty about where the Central Bank’s (CBI) monetary policy is headed. A darkening short-term inflation outlook will certainly give the CBI no cause for joy, although the bank knows full well that a commodity-driven inflation spike is beyond the scope of domestic monetary policy. It is primarily the knock-on effect on long-term inflation expectations and medium-term cost pressures that could cause the CBI to expedite its interest rate hikes. On the other hand, weaker growth in domestic demand would tend to mitigate the need for higher interest rates.

The monetary policy path the CBI takes in the quarters to come will depend on the indirect impact of commodity price hikes, on the one hand, and developments in the war and its effects on the global economy, on the other. On this front, Iceland is in much the same position as its neighbouring countries, as bond market rates have fluctuated widely but still generally reflect expectations of rising policy rates in the coming term.

GDP growth

It is quite likely that GDP growth will be weakened as a result of the war and the responses to it. As is discussed above, export growth could be adversely affected. Private consumption growth can also be expected to suffer somewhat. Higher imported inflation cuts into households’ purchasing power, and consumer sentiment as measured by Gallup will probably grow markedly bleaker in coming surveys. Consumer sentiment and private consumption tend to track one another closely, as households clutch their wallets tighter when uncertainty and pessimism gain ground.

That said, it should be noted that various factors are likely to mitigate the negative economic impact for Iceland:

• Iceland is a commodity exporter no less than a commodity importer, so the net effect of rising global market prices will be somewhat neutralised, as is noted above.
• Compared with many other European countries, Iceland has limited economic ties to Russia.
• The domestic economic recovery is well underway, making it less likely that war-related headwinds in specific sectors will spread throughout the economy. For instance, there are a large number of jobs available for those who might become unemployed as a result of the war.
• Home heating and electricity in Iceland come solely from domestic producers and are more or less immune to the surge in global energy prices.
• The authorities still have considerable scope for mitigating action if the economic recovery appears to be in jeopardy. For example, the pandemic was somewhat less onerous for the Government than was originally feared, and the CBI could take a detour from its monetary tightening path and ease financial conditions if it sees the outlook darkening substantially.

As is mentioned above, the situation in Ukraine is enormously uncertain, as is the overall impact the war will have. The future depends on developments in the war itself and the position of Ukraine, Belarus, and Russia once it is over. In our opinion, however, it is unlikely that the Icelandic economy will suffer a shock like that caused by the pandemic, and it is highly probable that the economic recovery will continue, although it may hit a rocky patch as a result of the war.