OECD Economic Outlook, Volume 2019 Issue 1

Iceland

The economy will slow significantly as exports, in particular tourism, decline because of the insolvency of a major domestic airline. Household consumption growth will ease on the back of moderate wage growth. Business investment will gradually recover from the current trough, but housing investment will ease further following a wave of new construction. Unemployment will edge up as the economy slows, and the current account surplus will narrow.

Inflation and inflation expectations are rebounding as the króna is depreciating and wages are rising above productivity. The central bank should act to keep inflation within the target band if price pressures persist. Fiscal policy is expansionary and should be less so, although higher infrastructure spending could help boost productivity. Comprehensive regulatory reform is needed to maintain competitiveness and high wages.

Growth is slowing

The economy is slowing rapidly, mainly due to several temporary export shocks. Tourist arrivals are declining after a low‑cost Icelandic airline has gone insolvent, cutting the number of flights to the country. A bad start to the fishing season and a partial shutdown in the aluminium industry add to the shock. The global economic slowdown has further weakened the demand for goods and service exports.

Household demand, including for imports, is easing on the back of the recently concluded wage agreements. Business investment remains weak after the termination of large construction projects and because business confidence is low. The labour market is easing and unemployment has started to rise, especially after the airline’s demise. With external demand weakening, the current account balance is narrowing. Capital flows remain inconspicuous despite further liberalisation of capital controls.

Tourism and inflation: Iceland

Source: OECD Economic Outlook 105 database; and Statistics Iceland.

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Iceland: Demand, output and prices

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Policy is accommodative

Inflation is overshooting the central bank’s target mainly because of wage drift and rising import prices due to a weakening of the króna, although the upward trend has recently slowed following the interest rate hike in November 2018. The policy rate is projected to rise again over the projection period. The central bank should stand ready to increase rates even further if inflationary pressures persist, which will also help stabilise the króna and reduce the risk of sudden capital flow reversals. Financial markets remain inconspicuous, and house prices have eased further.

The fiscal stance is expansionary. The projection includes spending increases, in particular for infrastructure, which will help boost potential growth. Cuts in income taxes and social contributions for low‑income earners will strengthen work incentives and help reduce income inequality but the budget will turn from a surplus to a small deficit. Fiscal policy should be less expansionary, mainly through a smaller increase in public consumption, to help reduce debt and build fiscal space. On current policies, public debt will decline only gradually.

Competitiveness is on a long‑term decline as wages are rising faster than productivity. The competitive edge gained after the 2008 crisis, when the króna devalued sharply and real wages were cut, is exhausted. To boost productivity and ensure continuing high salaries, Iceland should further open its economy and dismantle excessive regulatory barriers in domestic services and on foreign investment. The education system should better respond to labour market demands and prepare for rapid technological change.

Growth will continue to slow

Growth is projected to slow to 1% in 2019, mainly because of weaker revenues from foreign tourism on the back of the global slowdown and the airline’s insolvency. Growth will rise to 2.4% in 2020 as temporary factors affecting exports of goods and services fade. Business investment will recover gradually as capacity constraints will bite again, and household consumption will grow more strongly. Government spending, in particular on infrastructure and social services, will be supportive. Inflation is projected to remain under control. The small size of the economy makes it volatile and vulnerable, and continuing bad fishing seasons, falling aluminium prices or collapsing tourism can quickly translate into stalling growth.