Economic forecast to 2029: Slow growth but improving outlook
There are several indicators of declining underlying inflation pressure and, if our forecast holds, interest rate cuts will commence in the new year.
Reduced uncertainty on the home front a hopeful sign
Uncertainty has decreased considerably in Iceland in recent weeks and, in many respects, there is reason to view the outlook positively. We consider the interest rate hiking cycle to be over and uncertainty regarding the continuation of wage agreements has declined. This contributes to an improved outlook and we consider it likely that interest rate cuts can begin in early 2027. This does not mean, however, that the coming winter will be easy. We forecast a further increase in unemployment in winter, followed by a gradual decline next year. The real estate market has been quiet and private consumption growth has slowed. Uncertainty about developments abroad, most notably oil prices, remains high.
We forecast 1.3% economic growth this year and 1.5% next year. In a historical context, this is very moderate growth. It will be carried by diverse exports, with aluminium exports recovering alongside growth in tourism and continued burgeoning of new and varied growth sectors. We forecast a contraction in residential housing investment over the next few years and very modest increases in housing prices. A number of larger investment plans are expected to continue progressing, including projects related to power generation and data centres.
Inflation has peaked
Inflation has been above 5% the entire year. We maintain that a peak was reached at 5.9% now in fall. That being said, inflation will be sticky over the coming months, but if our forecast holds, it should fall below 5% in the first quarter of next year. Domestic conditions support this scenario, with a slack building up both in the labour and housing markets. Agreement was reached in the labour market earlier this month so that current collective agreements remain in force and the government has pledged to curtail increases in public fees.
We expect that the Monetary Policy Committee will see their way to initiating a rate-cutting cycle in February, with interest rate levels trending downwards alongside falling inflation. Real interest rates will stay fairly stable throughout the forecast period, peaking at just over 3% and generally ranging between 2-3% while inflation dwindles towards the target.
Highlights of the economic forecast to 2029
- Economic growth will be 1.3% this year, 1.5% in 2027 and 2% in 2028. Next year’s growth will be carried by increased exports. Aluminium exports will recover while varied growth sectors like data centres, pharmaceuticals and aquaculture bring increased growth.
- Inflation recedes and we consider the rate hike period over. We forecast 5.5% average inflation this year, 4.3% next year and 3.4% in 2028. Moderate increases in wages and public fees alongside falling demand will make initiation of rate cuts possible after the turn of the year.
- The Icelandic króna has appreciated a great deal, attaining a level that is unsustainable in the long term. Depreciation will occur yet despite a weaker króna, the real exchange rate will decline but slowly as higher inflation here as compared to trading partner countries counteracts that development.
- Private consumption growth will slow considerably, increasing by a mere 0.9% this year and then 1-3% per year to the forecast horizon. High interest rates, increased unemployment and slower purchasing power growth have dampened households’ willingness and capacity to consume. We believe that private consumption will pick up slowly when interest rates begin to decrease and that households will increasingly take advantage of built-up savings.
- Capital formation will stay broadly unchanged year-on-year this year and contract next year as investment in data centres tapers off. Heavy industry investment will remain considerable throughout the forecast period.
- The outlook is for considerable export growth next year, or 3.3% after little growth this year, or 0.6%. The outlook improves next year as aluminium export recovers from the malfunction at one og Norðurál’s potlines. We expect an increase in flight availability which supports tourism. Growth sectors continue to boost export growth, mainly aquaculture, data centres and pharmaceuticals. All taken together, exports will grow by 2.6% and 2.7% in the latter two years of the forecast period.
- Wage drift decreases in tandem with a cooler economy. We do expect a 5.1% wage increase next year, following on the heels of a 5.8% increase this year. Purchasing power increases but little this year and next but more in the latter years of the forecast period alongside lower inflation. Unemployment will be fairly high this year, or 4.5%, and 4.4% next year while interest rates remain high and the economy is in a slow-growth phase.
- The housing market remains quite and we expect moderate price increases in the in the near term. Housing supply has grown rapidly while demand has dropped. We assume that nominal prices will increase by 1.9% this year and 2% next year, leading to a decline in real prices both years. In the latter years of the forecast period, when interest rates have decreased and demand picks up, we anticipate rather higher increases in nominal prices.
