OECD Economic Outlook, Volume 2023 Issue 2

Iceland

Economic growth will drop to 2.0% in 2024 and edge up to 2.3% in 2025. Private consumption will ease as real wage growth is modest. Business investment will moderate as financial conditions continue to deteriorate and confidence remains lacklustre. Despite tighter financial conditions, housing investment will pick up to satisfy pent-up demand. Public investment will decline in 2024 and remain subdued in 2025. Goods exports and foreign tourism will slow. The unemployment rate will rise gradually to around 4.5%.

In August, the central bank lifted the key policy rate to 9.25%. Consumer price inflation is declining but still at around 8%. It is expected to fall further but remain above target until well into 2025. Fiscal policy is already contractionary and is projected to be tightened further, as planned by the government, to help reduce inflationary pressures and maintain fiscal space. A new tourism strategy should help increase productivity of the tourism sector and reduce pressure on infrastructure and the environment.

The economy is gradually slowing

The economy is weakening, although growth continues to benefit from strong foreign tourism. Activity in the seafood and aluminium sectors, Iceland’s main goods exports, is easing as demand in major export markets has weakened. Household consumption is moderating as real wage growth is sluggish and dissaving has probably come to an end. Business investment is tailing off as financial conditions are worsening, although business sentiment has improved since the early summer. Public investment is declining. The labour market remains tight, with the unemployment rate at around 3.5%, and the labour force is expanding following continued immigration. With seismic movements on the Reykjanes peninsula ongoing, several thousand inhabitants have been evacuated and activity in the area concerned has largely stopped.

Iceland: Economic growth and monetary, inflation indicators

Source: OECD Economic Outlook 114 database; Central Bank of Iceland; and OECD Consumer Prices database.

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Iceland: Demand, output and prices

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Monetary and fiscal policies continue to be tightened

In August, the central bank raised the key interest rate by 50 basis points to 9.25%, the 14^th increase since the tightening cycle started in May 2021, and kept it unchanged in November. Headline consumer price inflation fell from a peak of around 10% in February 2023 to around 8% as import and house prices declined, but it remains above the target of 2.5%. Underlying inflation has become more broad-based. The króna has depreciated since late summer. Fiscal policy was contractionary in 2023 and will be tightened further by around 1.0% of GDP per year following planned tax reforms and cuts in discretionary spending. The overall budget is projected to be close to balance in 2025. This is welcome to help reduce inflationary pressures and to build up fiscal space. The public debt-to-GDP ratio according to the national accounts is projected to decline slightly.

The economy will slow

Economic growth is expected to drop to 2.0% in 2024 and to rebound to 2.3% in 2025. Consumption will remain muted as real wage growth remains weak. Goods exports will tail off as demand in the destination countries loses momentum. Foreign tourism will slow as domestic capacity limits become more apparent and economic growth remains subdued in major origin countries. Tighter financial conditions will weigh on business investment. Despite higher real interest rates, housing investment will recover in 2024 and 2025 as pent-up demand is worked off. The unemployment rate will edge up towards 4.5%. Inflation will fall in the wake of macroeconomic policy tightening but is projected to remain above target until late in 2025. It could remain higher than expected if wages rise faster than agreed in the past wage agreements or if import prices, notably for oil, start rising again. The impending volcanic eruption on the Reykjanes peninsula could wreck a geothermal power plant and the “Blue Lagoon” resort. The tourism sector could also suffer from a stronger-than-expected slowdown in foreign tourists’ origin countries. A sharp fall in house prices could expose financial vulnerabilities.

A tourist tax could generate revenue and help safeguard natural resources

Iceland hosts more tourists per inhabitant than any other OECD country. Foreign tourism provides welcome employment and revenue, but it also exerts pressure on infrastructure and the environment, which has become a major structural policy challenge. A balanced tourism strategy could help improve productivity of tourism services; capitalise on the natural assets that form the basis of Iceland’s tourism sector; limit pressures on infrastructure and the environment; and aim for a geographically more even development across the country. Iceland should introduce a tourist tax to generate additional tax revenue, to help safeguard natural resources and to finance and manage public infrastructure.