The Economic Environment

Private consumption gives way to exports

Inflation had been nudging 10% from mid-2022, and at the beginning of the year it was evident that further action was needed to bring it under control. Inflation was no longer a word just used by economists but had found its way again into everyday conversation. The Central Bank of Iceland’s monetary policy committee, which had been hopeful that victory against inflation was at hand, found itself forced to inject more urgency into its policy rate hikes. The Central Bank’s main interest rates were raised by 0.5 points in February, 1 point in March and 1.25 points in May. By the summer, policy rates topped inflation for the first time in more than two years, while real policy rates had become positive by other metrics earlier in the year. The last policy rate hike of the year, and possibly the last in the current cycle, came in August and brought rates up to 9.25%. Seismic activity on the Reykjanes Peninsula and the imminent threat of a volcanic eruption in Grindavík in November resulted in the postponement of further rate hikes even though they were probably necessary.

Some success was achieved in the first half of the year, and inflation was down to 7.6% in July, but this was the lowest level it reached, despite that the fact that imported inflation had been significantly reduced. Prices of domestic goods continued to rise sharply, and the price of housing continued to be a major contributor to inflation. However, the inflation outlook improved somewhat towards the end of year, just after the decision to keep policy rates unchanged, and the year ended with an apparent air of optimism. A general consensus seems to have been reached throughout the nation that inflation has to be brought under control.

After running at a substantial deficit in recent years, it was high time that there was a turnaround in government finances. A tighter stance was adopted, but all this means is that the annual deficit is estimated to be ISK 54 billion, compared with ISK 97 billion in 2022. This was achieved by increasing income by 13.6%, while expenditure grew by 9.2%, and the austerity measures were perhaps chiefly concerned with ensuring that expenditure did not outpace income. The state of the government finances suggests that the government intends to outgrow the problem rather than resort to painful cutbacks. Although austerity is increasing, it is up to the monetary policy to bear the brunt in order to stabilize the economy.

Tighter monetary and fiscal policies gradually reduced overheating in the economy. Over the whole 12 months GDP growth was probably decent, but this was mainly due to how strong it was in the first half of the year. GDP growth not only began to recede, but its composition also changed. Private consumption was overtaken by tourism, and it might be said that restaurants began to cater for foreign customers rather than Icelandic diners. This is actually a fairly healthy development as there are limits to how much an economy can grow on the back of private consumption alone. Investment also began to drop during 2023, both public investment and housing investment.

The resurgence of tourism also resulted in the return of the current account surplus, and the higher balance of services more than compensated for the increased trade deficit.

The main news when it came to the exchange rate of the Icelandic króna was that there was little to report. The exchange rate has rarely seen such little volatility over the course of a year. After a short-lived period of depreciation at the beginning of the year, the exchange rate remained stable to begin with. It then appeared that expectations of an influx from the sale of Kerecis to Coloplast triggered the strengthening of the króna in the summer when the EURISK dropped almost 5% in two months. In the first eight months of the year the króna gained 6.8% against the euro, but this began to reverse, particularly in November when uncertainty over the volcanic situation on the Reykjanes Peninsula reached its peak. The slide was halted when the Central Bank intervened in the currency market for the first 10 months of the year, and news of the possible acquisition of Marel by JBT Corporation also had a positive impact. The króna ended the year 1% stronger than the euro than at the start of the year.

There was a major labour shortage in many sectors of the economy. At the beginning of the year 53% of companies claimed that they had a shortfall of workers, a similar figure to 2007. The shortage was greatest in the construction industry, but the tourism industry undoubtedly provided a lot of jobs. Substantial wage increases and rising real interest rates did therefore not result in higher unemployment. In fact, the opposite happened, unemployment continued to decrease.

Wage increases had been substantial in 2022, and in December of that year the wage index increased by 4% between months. Labour market participants clashed at the beginning of the year and were unable to strike a long-term deal, with the outcome being a 1-year agreement, something which neither employers nor the unions seemed particularly pleased with. Wage increases in 2023 were probably more moderate than the previous year, and in the first 11 months of the year the wage index rose by 6.5%. Towards the end of the year labour market participants were starting to discuss the next phase and the tone was more conciliatory on both sides of the negotiating table.

Although efforts to rein in inflation only met with limited success, there were clear signs in the second half of the year that the economy was beginning to slow down. In April the real year-over-year change in domestic card turnover had become negative, indicating a slowdown in private consumption which turned into a contraction in the third quarter. Lower private consumption materialized in many different ways. People began to travel abroad less in the second half of the year and imports of durable and semi-durable goods, such as clothing and home appliances, dropped. It could be argued that the people of Iceland were now paying the price for the Covid-19 crisis which they hardly felt at the height of the pandemic.

A restrictive monetary policy and tightening conditions on the credit market meant that housing prices finally began to ease, although the housing market continued to spring surprises as price increases still outstripped expectations. Following steep policy rate cuts in the spring, it appeared that property prices might be about to drop. The property market recovered in the autumn, however, shortly after the rules on state subsidized mortgages were relaxed, and indeed during the third quarter the number of first-time buyers skyrocketed. Indexed loans have also sheltered borrowers from high interest rates and enabled people to buy homes, yet at the same reduced the effectiveness of the monetary policy on the property market. In the autumn indexed loans once again accounted for half of outstanding loans, a trend which is certain to continue. Finally, it should be noted that there has been a huge population increase over the last two year and this has buoyed demand.

Despite the fact that property price increases have slowed down significantly, housing is still the major driver of price increases in the consumer price index due to the fact that calculations of the housing component take into account indexed interest rates. Imputed rent for housing therefore increased by 12.1% even though housing prices grew by only 4.2%. For example, the price of housing in Iceland as a proportion of wages decreased by 6.3%, but due to higher interest rates the proportion of wages needed to repay loans when buying a property increased.