OECD Economic Outlook, Volume 2022 Issue 1

Iceland

The economy is projected to grow by 4.2% in 2022 and 2.8% in 2023, driven by buoyant goods and services exports. Household consumption will slow in the course of 2023 as real wage growth is set to cool. Worsening financial conditions and uncertainty related to the consequences of the war in Ukraine is expected to weigh on business investment, but investment in residential housing will remain solid. Unemployment will continue to decline slightly, to around 4.5% at the end of 2023.

In early May, the central bank lifted the policy rate to 3.75%, the sixth rate increase within a year as inflation is accelerating and long-term expectations are rising. The central bank should increase interest rates further should inflationary pressure persist. Fiscal policy will be contractionary as planned by the government, which is welcome. Regulatory reform in the energy sector could make energy supply more sustainable, reliable and resilient.

The economy has exited crisis mode

The economy has successfully exited the COVID-19 crisis but the impact of the war in Ukraine is looming, although trade with Russia and Ukraine is negligible. Exports of goods and services remain strong, especially tourism which is benefitting from the removal of almost all restrictions. Business investment is slowing as uncertainty is rising, confidence declining and financial conditions worsening. Household consumption remains solid after significant wage increases. The unemployment rate stands at around 5%, and labour shortages have become more apparent. By the end of April, around 2 000 Ukrainian refugees (equivalent to around 0.7% of Iceland’s population) had received asylum, including immediate access to the labour market, public services and free health care.

Iceland: Economic activity and inflation indicators

1. Inflation data for May 2022 are preliminary.

Source: OECD Economic Outlook 111 database; Statistics Iceland; European Central Bank; and OECD Database on Consumer Price Indices.

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Iceland: Demand, output and prices

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Macroeconomic policies are restrictive

Monetary policy continues to tighten. In early May, the central bank raised the interest rate by 100 basis points to 3.75%, the sixth increase since normalisation started in May 2021. Headline inflation has accelerated to 7.6% in May, driven by rising housing, food and commodity prices. Long-term inflation expectations are also drifting up. The króna has appreciated slightly over the past few months. The policy rate is projected to climb to almost 5% by the end of 2023, with inflation expected to subside to around 3%. The structural balance is improving by around 3 percentage points of GDP per year until 2023 according to the fiscal plan published in April, which is appropriate, subject to additional public spending for reception and integration of Ukrainian refugees.

The economy is set to cool

The economy is projected to grow by 4.2% in 2022 and 2.8% in 2023, driven by strong goods and services exports. Economic slack will continue to diminish. Household consumption will remain solid in 2022 but slow in 2023 as wages decelerate. Business investment will decline due to deteriorating financial conditions, rising uncertainty and the completion of pent-up projects, although spending on ships and aircraft will provide some support. Residential investment should remain robust thanks to solid housing demand. The unemployment rate is expected to fall to around 4.5% by the end of 2023. Despite fiscal tightening, public debt will rise from around 78% of GDP in 2021 to around 82% in 2023.

The projections are subject to considerable uncertainty and risks. Consumption and investment could suffer because of extended uncertainty about the war’s impact as well as rising food and commodity prices. Inflation could become persistent. Foreign tourism might decline again if economic conditions are weaker than projected in the home countries of visitors. Domestic shocks such as a very strong volcanic eruption could interrupt transport links.

Policies to strengthen energy sustainability

With geothermal and hydropower covering around 90% of energy demand, Iceland relies overwhelmingly on domestic, renewable and reliable energy sources. The low share of fossil fuels in energy consumption and the lack of a physical connection to the European electricity grid shelter Iceland largely from the fallout of energy market imbalances. To maintain energy independence and ensure that the recovery remains resilient and sustainable, the government should continue to support energy diversification, notably by supporting investment in wind energy and by reforming the regulatory framework for energy generation, transmission and distribution, to ensure fair competition among providers.