The economy continues its robust expansion, driven by strong private consumption growth, a terms-of-trade boost and a boom in tourism. Large investments in energy-intensive projects and continued strong wage growth are fuelling domestic demand. The capital controls introduced during the financial crisis will begin to be lifted in 2016.

Inflation has been modest in early 2016 at around 2%, and has been held down by exchange rate appreciation and falling energy prices. However, underlying inflationary pressures are strong and monetary policy should therefore remain tight, which will slow growth in 2017. Fiscal policy is eased in 2016, but still targets a primary surplus, which coupled with windfall receipts arising from the lifting of capital controls will bring down government debt.

Labour productivity growth has been negligible since the crisis. In part this reflects a compositional shift towards low-productivity sectors, such as tourism. Toughening competition policy to stop abuse of dominant positions and tacit collusion, and lowering legal barriers to entry would boost productivity growth.

The economy is booming

The economy continues its robust recovery, underpinned by strong private demand, a surge in investment activity and a boom in tourism. Household income continues to benefit from the double digit wage increases awarded in 2015. In March, wage growth accelerated to around 13% relative to a year earlier. These pay rises are far above productivity growth, which remains subdued, and will affect competitiveness. Employment growth has also been robust, bringing the unemployment rate down to just 3.1%. The tourism boom has continued and is supporting construction. In addition, investment in a number of energy-intensive projects is boosting business fixed investment during 2016.

Wages and output and unemployment

1. The output gap is the three-month centred moving average inverted.

Source: OECD Economic Outlook 99 database; and Statistics Iceland.

Macroeconomic policies need to tighten

Inflation has remained below the central bank’s target of 2½ per cent, reflecting the appreciation of the Krona and the fall in energy prices. Longer-term inflation expectations have begun to stabilise, but some way above the central bank’s target. However, considerable inflationary pressure has built up, not least owing to the high wage increases. The central bank needs to prevent a wage-price spiral emerging and establish monetary policy credibility if it is to achieve low and stable inflation. The projections assume that the short term interest rates on 7-day deposits will rise above 6% from the second quarter of 2016.

Demand, output and prices

The budgetary position has improved substantially and a surplus is assumed for 2016 and 2017, although the underlying primary balance will deteriorate somewhat. Substantial windfall receipts, expected to be around 13% of GDP, from agreements with the estates of the failed banks (part of the plan to lift of capital controls) should be used to reduce public debt as planned, thereby reducing high interest payments. Given demand pressures, fiscal policy should tighten to prevent overheating.

Lethargic productivity growth in part reflects the shifting composition of the economy towards tourism, but productivity is generally weak except in fishing and energy-intensive metallurgy. The small size of the economy can limit opportunities. However, a number of artificial barriers and anti-competitive behaviour of incumbents limit competitive pressures. Reducing barriers to entry and enforcing competition policy robustly to prevent abuse of dominant position or tacit collusion would boost productivity.

Output growth will remain robust with risks of overheating

Robust income growth and investment will support the economy in 2016. Maintaining a relatively tight monetary policy combined with the moderation of investments in energy-intensive projects will eventually begin to slow the economy and slacken employment growth, edging up the unemployment rate. However, wage increases remain particularly strong and the danger of a wage-price spiral is acute. In an election year it is imperative for macroeconomic policy to remain tight. Fiscal policy needs to resist calls for relaxation when the large windfall receipts from reaching agreements with bank resolution committees are received.