OECD Economic Outlook, Volume 2023 Issue 1

Iceland

Economic growth will come down to 4.4% in 2023 and 2.6% in 2024. Private consumption will slow as wages moderate. So will business investment as financial conditions continue to tighten, and public investment will barely grow. In contrast, residential investment will pick up in the near term to work off pent-up demand. Export growth will slow given only modest growth in major trading partners. The unemployment rate will gradually rise towards 4.5% by the end of 2024. Headline inflation is expected to decline from around 10% in early 2023 to around 3% by late 2024.

In May, the central bank lifted the policy rate to 8.75%, the thirteenth increase since tightening started in May 2021 at 0.75%. The policy interest rate could be raised further to re-anchor inflation expectations and bring back inflation towards the 2.5% target. The fiscal consolidation planned for 2023-24 is appropriate to reduce inflationary pressures and maintain fiscal space. To foster sustainable productivity growth and help diversify the economy, innovation should be strengthened further, and the gender balance should become more equal across sectors.

Growth has peaked

The economy is slowing gradually, despite foreign tourism heading rapidly towards pre-pandemic levels. Exports of goods and services rich in energy content are weakening as global energy prices have come down. Household consumption is moderating. The late 2022 wage agreements may have halted the decline in real wages. Business investment is slowing as financial conditions become tighter and confidence declines. Government investment is barely growing. Inflation is hovering at around 10% since early 2023. The labour market remains tight, with the unemployment rate at around 3.5%, and labour participation continues expanding.

Iceland: Economic growth and monetary, inflation indicators

1. The sum of components may deviate from observed GDP growth because of balancing items, chain-linking procedures and direct/indirect seasonal adjustment methods.

Source: OECD Economic Outlook 113 database; Statistics Iceland; and Central Bank of Iceland.

Statlink

Iceland: Demand, output and prices

Statlink

Monetary and fiscal policies continue to be tightened

In May, the central bank raised the interest rate by 125 basis points to 8.75%, the thirteenth increase since the cycle started in May 2021. Headline consumer price inflation peaked at around 10% in February and has flattened since as house prices are slowing, but underlying inflation has become more broad-based. The policy interest rate is expected to rise further to peak at around 9% in mid-2023. The króna has slightly appreciated over the past few months. Fiscal policy, which was contractionary in 2022, is projected to be tightened further in 2023 and 2024. This is necessary to counter inflationary pressures and to build up post-pandemic fiscal space.

The economy will slow

Economic growth is expected to decline from 6.4% in 2022 to 4.4% in 2023 and 2.6% in 2024. Household consumption will slow as real wages continue to decline. Export growth of energy-intensive goods will moderate as global energy prices will remain below their peak of 2022. Foreign tourism will no longer expand as fast, as domestic capacity limits become more apparent and economic growth remains moderate in major origin countries. Tighter financial conditions will weigh on business investment. Housing investment will recover in 2023 as pent-up demand is worked off but will abate in 2024 as higher real interest rates bite. The unemployment rate will edge up towards 4.3%. Inflation will gradually slow in the wake of macroeconomic policy tightening, although it is projected to stay above target at the end of the projection period. Inflation could remain higher than expected if wages are rising faster than agreed in wage settlements, triggering a wage-price spiral. Global financial risks, including the bank failures seen in the United States and Switzerland, could contaminate Iceland’s domestic financial sector. A sharp fall in house prices could spark a financial crisis.

Fostering innovation could underpin growth

Iceland outranks many European countries in terms of overall innovation performance, including cutting-edge technology for carbon capture and sustainable fish farming. Firms perform well overall in the adoption and use of digital technologies, although smaller firms tend to lag. To foster sustainable growth and help diversify the economy further, regulatory reform should ease market access for young and innovative firms. Adoption of new technologies, notably digital, should be encouraged further. The education system should provide more relevant skills and contribute to a more equal gender balance across professions and economic sectors, especially in areas that are important for a creative and innovative economy.