OECD Economic Outlook, Volume 2018 Issue 1

Iceland

After expanding strongly in recent years, the economy is projected to gradually approach its potential growth rate. Household consumption will remain robust on the back of strong wages and continuing immigration. Business investment is set to start rising after its recent slump, while residential investment will decelerate. The growth of manufacturing exports will slow as competitiveness declines, while tourism demand will remain strong.

Inflation is picking up. The central bank is projected to raise interest rates to contain price increases. Although a budget surplus is planned for 2018, fiscal policy should be more prudent than projected since the economy still runs way above its potential. Public spending in particular should grow less. A more vigorous competition policy would improve the business climate and spur productivity.

Growth is slowing gradually

Growth continues to slow, although the economy still operates at capacity limits. House price inflation has eased markedly. Tourism is turning to a more sustainable path, while exports of manufactured goods declined, partly as a result of deteriorating competitiveness. Business investment is slowing as a result of lower external demand. Capital inflows have eased and become less volatile. Household consumption remains robust on the back of strong wage increases and continued immigration. The current account remains positive.

Monetary and fiscal policy should be tight

Inflation is below the central bank’s target but edged up at the beginning of 2018, mainly as a result of house price increases outside the capital region. The inflation‑dampening effect of the krona’s past appreciation is tapering off. The policy interest rate is projected to be raised gradually to around 5% until 2019, in particular to contain domestic demand and inflation. The result of wage settlements is still unclear, adding uncertainty to the inflation outlook.

Iceland

Source: OECD Economic Outlook 103 database; and Thomson Reuters.

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Fiscal policy is too expansionary. The projection foresees considerable spending increases, in particular for transport and social infrastructure, and cuts in taxes, as planned by the government. Although the budget remains in surplus and fosters inclusive growth, fiscal policy should be overall tighter as the economy still runs close to capacity limits. Less expansionary fiscal policy could also help reduce inflationary pressure.

Iceland. Demand, output and prices

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Labour productivity is low compared to other Nordic countries, but living standards are kept high by high labour force participation. The small size of the economy limits the scope for economies of scale and for effective competition among firms. Still, competition is often weak due to artificial barriers to entry. As a consequence, a vigorous competition policy would improve the business climate and spur productivity growth.

Growth is projected to slow

Growth is projected to slow to 2.8% in 2018 and 2.6% in 2019, which is closer to its potential rate, owing to weaker business investment and lower exports. Investment in public infrastructure will partially offset the decline in business investment and help increase economic capacity in the longer term. Tourism will continue to slow to more sustainable growth. Large wage increases following collective agreements could undermine competitiveness. Given its small size, the economy remains subject to high volatility.