OECD Economic Outlook, Volume 2022 Issue 2

Iceland

Economic growth will slow to 2.5% in 2023 and 2.3% in 2024. Private consumption will weaken as wage growth moderates and dissaving comes to an end. Business and housing investment are likely to decrease as financial conditions continue to tighten, and public investment will also decline in 2023-24. Export growth will remain strong thanks to robust growth of foreign tourism. The unemployment rate will rise gradually to around 4.5%. Headline inflation peaked at around 10% in late summer and is expected to subside over the projection period.

In early October, the central bank lifted the policy rate to 5.75%, the ninth increase since tightening started in May 2021. The bank is projected to tighten further to bring inflation back to target in due course. The fiscal consolidation planned for 2023-24 is appropriate to reduce inflationary pressures and maintain fiscal space. Investing in energy diversification and research and development could help improve energy security and achieve the government’s climate targets.

Strong exports are driving the economy

Iceland’s economy is growing rapidly, benefitting from rising exports of energy-intensive products, such as aluminium, which have been expanding steeply over the past few months. Foreign tourism is also recovering rapidly from its pandemic-induced collapse. Household consumption remains strong on the back of continued wage growth and dissaving, although real wages have started to decline in the wake of high inflation. Business investment is stalling as confidence declines and financial conditions tighten. The labour market remains tight, and labour shortages have become more apparent. Around 2 500 Ukrainian refugees (0.7% of the population) have found shelter in Iceland, with immediate access to the labour market.

Iceland

Source: OECD Economic Outlook 112 database; Central Bank of Iceland; and OECD database on Consumer Price Indices.

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Iceland: Demand, output and prices

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Fiscal and monetary policies are tightening

Monetary policy continues to tighten. In early October, the central bank raised the interest rate by 25 basis points to 5.75%, the ninth increase since the cycle started in May 2021. Consumer price inflation peaked at around 10% in late summer and is ebbing, as housing, food and commodity prices moderate. Inflation expectations are also subsiding. Since the spring of 2022, the krona has depreciated by almost 10% against the US dollar but has hardly moved against the euro. The central bank is projected to raise interest rates further to around 6¼ per cent in 2023 to bring inflation back to target.

Fiscal policy has already tightened and is projected to tighten further by around 3% of GDP in 2023 and 0.6% of GDP in 2024. This is appropriate to counter inflationary pressures and to build up post-pandemic fiscal space, although growth is projected to slow significantly. Gross public debt is projected to climb from around 78% of GDP in 2022 to around 81% in 2024, reflecting persisting fiscal deficits.

The economy will slow considerably

Economic growth is expected to moderate from 6.4% in 2022 to 2.5% in 2023 and 2.3% in 2024. Household consumption will slow as real wages continue to weaken. Tighter financial conditions and rising uncertainty will weigh on business investment. Energy-intensive sectors and services will drive export growth. Housing investment will recover in 2023 as pent-up demand from 2022 is realised, but it will abate in 2024 as higher interest rates bite, given the expanding share of variable-interest mortgages. Public investment will be cut as planned by the government. The unemployment rate will rise to around 4.5%. Inflation will decelerate in the wake of tighter policy, although it is projected to stay above target at the end of the projection period. The small size of the economy makes it volatile and vulnerable. Goods and service exports could suffer from a stronger-than-expected slowdown in major trading partners. Domestic shocks, such as a bad fishing season or a decline in viable fishing stocks, could reduce exports of marine products. Investment could take an additional hit if financial conditions worsen further and uncertainty about the impact of the war in Ukraine persists.

Investing in energy diversification and security is important

Iceland depends overwhelmingly on domestic, reliable and renewable energy sources, with geothermal and hydro power covering around 90% of energy demand, much more than in any other OECD country. The country is largely sheltered from the fallout of energy market imbalances, except for oil powered cars and the fishing fleet. To maintain energy security, 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. Investing in low-carbon infrastructure would yield a double dividend by helping improve energy security and achieve climate targets.