Interest rates have fallen, inflation has eased and Statistics Iceland estimates modest economic growth in the third quarter. All of this has come to light in the past two weeks and it is still unclear how quickly the economy will cool in the coming months. There are signs of increased slack in the labour market: Demand for workers has decreased and unemployment has risen. The ruling in the interest rate case and setbacks in export industries are contributing to the economy cooling faster than expected earlier this autumn. At the same time, households are sustaining strong demand through increased purchasing power and accumulated savings.
The November inflation measurement was a pleasant surprise, as inflation fell by 0.6 percentage points in one go. It now stands at 3.7% and has not been lower in five years. Although some of the decline is likely to reverse in December, we consider the inflation outlook to be brighter than before. We now forecast that inflation will remain just below four percent in the coming months, before it begins to ease as we move into next year. Setbacks in the export sectors have fuelled a rather sharp weakening of the ISK in recent weeks and we believe the exchange rate could continue to weaken gradually in the near future. Inflation developments partly depend on whether and how quickly the exchange rate continues to decline.
The Central Bank of Iceland lowered interest rates on November 19, contrary to the forecasts of most analysts, who believed that increased inflation in October and expectations of rising prices would prevent a rate cut. The Monetary Policy Committee justified the interest rate cut by arguing that reducing real monetary restraint could offset the additional tightening resulting from changes in loan offerings following the interest rate ruling. It could also be understood from the MPC that members believed it was clear that tension in the economy had eased significantly, and that further slack would emerge in the coming months. The CBI lowered its forecasts for inflation and economic growth for the months ahead.
Despite increasingly clear signs of cooling in the economy, economic growth measured 1.2% in the third quarter. As before, growth was driven by increased private consumption and investment, but the negative contribution of external trade weighed even more heavily. Had it not been for the positive effects of inventory changes, the quarter would have shown a contraction.
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