OECD Economic Outlook, Volume 2019 Issue 2

Iceland

The economy will recover amid a pick-up of foreign tourism and seafood exports. Consumption will remain moderate on the back of contained wage growth and rising social benefits. Business investment will slowly recover as interest rates decline. Unemployment will rise, although in a few high‑skill sectors labour shortages will become more apparent. Inflationary pressures will ease as wage drift has weakened and the krona has stabilised.

The central bank should continue to adjust interest rates in line with prospects for inflationary developments. Fiscal policy is projected to be broadly neutral following tax cuts and higher spending. Spending increases, especially on disability benefits, need to be restrained to ensure that debt continues to decline. Stringent regulations and restrictions on foreign direct investment, which weaken competition and hold back innovation and productivity, should be adjusted.

Growth is recovering

Growth is recovering gradually, as foreign tourism is stabilising and the capacity constraints in the airline sector are easing. Business investment remains weak after large construction projects have been terminated and because confidence is low. With exports weakening, the current account surplus is declining. Household consumption growth is robust on the back of moderate wage agreements and generous unemployment and social benefits. After declining for several years, the unemployment rate has risen sharply, to more than 4% in autumn 2019. House prices have stabilised following the recent increase in supply, lower immigration and declining demand related to tourism, but they remain high. Both corporate and household debt are hardly growing.

Exports and inflation and interest rate: Iceland

Source: OECD Economic Outlook 106 database.

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Iceland: Demand, output and prices

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Policy is neutral

Inflation is declining due to the strong krona and moderate wage increases, again undershooting the central bank’s target. With inflation expectations declining, the bank lowered interest rates in five steps from 4.5% in May to 3% in November 2019. The rate is expected to decline further given the outlook for inflation. Interest rates are at a historical low, though they remain significantly higher than in most OECD countries.

Fiscal policy is broadly neutral. Relief on income taxes and social contributions and a rise in social benefits help address impacts from the downturn, while raising the budget deficit. The projection includes discretionary spending increases going forward, as planned by the government, in particular on infrastructure towards the end of the projection period. Public debt will no longer decline. Fiscal policy should be more contractionary, especially by cutting spending on disability, to build up fiscal space.

Product market regulation is stringent and the administrative burden for start‑ups is high, holding back investment and innovation. Restrictions on foreign direct investment are among the highest in the OECD area, damping employment and productivity gains through lower international knowledge transfer. The government should set up a comprehensive action plan for regulatory reform, prioritising reforms that foster competition, level the playing field between domestic and foreign firms and attract international investment.

Growth will recover gradually

Growth is projected to recover to 1.6% in 2020 and 2.6% in 2021, as foreign tourism and seafood exports resume. Business investment will slowly recover as interest rates decline, and household consumption growth will ease as income growth slows. Government spending, in particular on infrastructure and social services, will be supportive. Inflation is projected to decline to 2%. The small size of the economy makes it volatile and vulnerable, and a deeper‑than‑expected global downturn can quickly result in a sharp fall in tourism revenues.