OECD Economic Outlook, Volume 2024 Issue 1

Iceland

Economic growth will decline to 1.9% in 2024 as exports slow but rebound to 2.8% in 2025. Private consumption will remain lacklustre in the near term, reflecting subdued real wages, but will pick up in 2025 as disposable income strengthens. Business investment will remain weak in 2024 as confidence is fragile but will regain momentum in 2025 as financial conditions ease. Housing investment will resume after three years of contraction. Foreign tourism will hardly grow due to capacity constraints. The unemployment rate will edge up to near 4%.

The central bank has left the policy rate unchanged at 9.25% since August 2023. Consumer price inflation is still high at close to 7%, and inflation is projected to remain above the target of 2.5% in 2024 and 2025, warranting continued central bank vigilance. Fiscal policy was contractionary in 2023 and is set to tighten further despite additional disaster‑related spending, to help reduce inflationary pressures and maintain fiscal space. Lower barriers to business entry, notably for foreigners, and less red tape in the professions could help spur underlying growth and diversify the economy.

The economy is slowing

Economic growth is slowing as foreign tourism is declining due to capacity constraints. Tourism is also being affected by closures of tourist sites such as the Blue Lagoon because of volcanic activity. Consumption is held back by low confidence and subdued, albeit rising real wages. Business investment remains weak as financial conditions continue to tighten. Housing investment is picking up. The unemployment rate is rising gradually but remains below 3.5% and the labour market remains tight with persisting labour shortages in some sectors. Eruptions continue to threaten the Reykjanes peninsula, damaging houses and infrastructure and requiring emergency measures such as building protective dams.

Iceland: Activity and inflation indicators

1. Passengers who go through security at Keflavík Airport. 12-months moving average.

Source: Statistics Iceland; and Central Bank of Iceland.

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Iceland: Demand, output and prices

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Monetary policy tightening has peaked, and fiscal policy remains contractionary

The central bank raised the key interest rate to 9.25% in August 2023 and has left it unchanged since. It is assumed to decline gradually starting in late 2024. Headline consumer price inflation has fallen from a peak of around 10% in February 2023 to below 7% but remains way above the target of 2.5%. Core inflation has also fallen but remains broad-based. Fiscal policy was contractionary in 2023 and will be tightened further by around 1.0% of GDP per year in 2024 and 2025 following planned tax reforms and cuts in discretionary spending. The overall budget is projected to be in small surplus 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 further in 2024 but rebound in 2025

Economic growth is expected to drop to 1.9% in 2024 and to rebound to 2.8% in 2025. Private consumption will remain muted as real wage growth remains weak, but it will pick up in 2025 following stronger pay rises. Foreign tourism will slow further as important tourist sites remain closed due to volcanic activity. Subdued growth in major origin countries will also weigh on tourism. Low confidence will affect business investment, which will however recover in 2025 as financial conditions ease. After contracting for three consecutive years, housing investment will pick up as interest rates decline and pent‑up demand is worked off. The unemployment rate will edge up to 3.9% in 2025. Inflation will fall in the wake of still tight macroeconomic policy but is projected to remain above target until late in 2025. It could exceed expectations if wages rise faster than agreed in wage settlements or if import prices, notably for oil, start rising again. The volcanic eruptions on the Reykjanes peninsula could intensify, damaging more infrastructure and requiring additional measures that weigh on public spending. Tourism could also suffer from weaker-than-expected demand in major origin countries. A sharp fall in house prices could expose financial vulnerabilities.

Improvements in the business climate and continued fiscal consolidation would help sustain growth

Iceland’s business climate as measured by the OECD’s product market regulation indicators remains rather unfriendly. Foreign access to some sectors is more restricted than in almost any OECD country, hampering sound competition. Considerable administrative burdens for new companies, and an extensive licensing and permit system, protect incumbents and hinder innovative start‑ups, slowing economic diversification. To help lift productivity, create more jobs, and diversify the economy, the government should speed up structural reform and foster an open and competition‑friendly business climate. Furthermore, the general-government financial balance should be kept close to zero to ensure that the debt-to-GDP ratio remains on a declining path.