Iceland seeks to exorcise its economic demons

Few developed European countries seem to be more haunted by their recent economic history than Iceland.

It’s not just memories of the traumatic banking crisis of 2008 that trouble Iceland’s policymakers today. Their uncomfortable memories stretch much further back than that.

Ásgeir Jónsson, governor of the Central Bank of Iceland, was explicit about this in the speech he delivered at the Bank’s annual general meeting in early April. This referred repeatedly to what Jónsson described as the “inflation demon” and its corrosive impact on Icelandic society in the 1970s.

Emergency legislation and other short-term measures were powerless then to prevent inflation ranging for most of the decade between 30% and 40% and peaking at 60% in 1979. With real interest rates reaching deeply negative territory, said Jónsson, many people who had worked hard all their lives saw their savings wiped out in a few years.

In some ways, Jónsson sees uncomfortable parallels between today and the 1970s. A decisive difference, however, is that since 2001 Iceland’s Central Bank has been independent. This has allowed it to respond with unforgivingly restrictive monetary policy to inflationary pressures threatening the sort of economic trauma Iceland suffered in the 1970s.

The Bank has not hesitated to flex its monetary policy muscles whenever and however it sees fit, hiking its policy rate 14 times between May 2021 and August 2023 to a current rate of 9.25%. The result, as Íslandsbanki put it in a recent update, is that Iceland is now facing its highest real interest rate — about 4% — for “donkey’s years”.

High interest rates are nothing new in Iceland. William Symington, head of international funding at Íslandsbanki, says that when rates plummeted to 0.75% during the Covid crisis it was the exception rather than the rule. “So Iceland as a society has never been accustomed to prolonged periods of low interest rates, as the rest of Europe and the US have been,” he says.

However accustomed to high rates they may be, many Icelanders think that enough is enough. Of the 29 bond market practitioners who responded to a survey published by the Central Bank at the start of May, 62% indicated that they thought the authorities’ monetary stance to be too tight. This was up from the 42% who said the Central Bank was being too hawkish at the time of the previous survey in January. Just over a third of respondents to the most recent survey thought the Central Bank’s monetary policy was appropriate.

That was hardly a vote of confidence from the market. But it’s unlikely to cut much ice with Jónsson. “I can assure you that the repercussions would have been far worse if the Bank had not responded,” the governor said in April, directing his remarks to those who have been critical of the authorities’ hawkishness. “That would have been a journey back to the past, and one that few of us would have chosen to take.”

He has a point. Inflation in the first quarter of this year reached 6.8% as measured by the 12 month rise in the consumer price index (CPI). This stubbornly high level, way above the Central Bank’s target of 2.5%, is attributable to the overheating of the economy between 2021 and 2023. Last year, the only OECD countries to outgrow Iceland were Costa Rica and Turkey.

Some local economists argue that the reported economic growth of close to 20% over the post-pandemic period between 2021 and 2023 paints a false picture. “CBI officials have repeatedly discussed — and, in our opinion, perhaps overemphasised — the strong accumulated GDP growth in 2021-2023,” notes Íslandsbanki. “It is worth noting, though, that this growth is partly a manifestation of the recovery from the steep contraction in 2019.”

Perhaps. The problem, says Arion Bank’s chief economist, Erna Björg Sverrisdóttir, is that those same bond market participants who say interest rates are too high also believe inflation will remain significantly above target. Survey respondents expect inflation to edge down to 4.6% in one year and 4% in two years. Over the longer term, they expect it to average 3.8% over the next five years and 3.5% over the next 10.

These expectations are more or less in line with, or slightly below, those published by local banks. In an update in April, for example, Landsbankinn warned that inflation would remain persistent over the next few months, averaging 6% this year before falling to 4.4% in 2025 and 3.5% in 2026.

The result is that Iceland will probably have to wait for rate cuts. Landsbankinn’s head of economic research, Una Jónsdóttir, says the first rate cut is likely to come in October. “We think we’ll see rates being cut repeatedly in 2025, but for the moment we think inflation will remain sticky throughout the summer,” she says.

“High rates have caused a slowdown in some ways,” Jónsdóttir adds. “For example, credit card turnover is decelerating. But at the same time, many people are benefiting from higher interest rates because households’ interest income exceeds their interest expenses as a percentage of their disposable income. So there is still scope for people to go out and spend money.”

This underscores a curious feature of Iceland’s economy, which is that many of its key macro indicators seldom respond as they should to restrictive measures, the most notable and orthodox of which is a restrictive monetary policy.

Maxim Rybnikov, director at S&P Global Ratings, says that Iceland’s monetary policy framework is the weakest in the Nordic region. He says that while on S&P’s scale of one to six (where one is the strongest), Iceland scores four for its monetary policy framework, compared with one for Sweden and Norway, and two for Finland.

“Part of the reason for this is that as so many goods are imported, monetary conditions and pricing levels are determined more by what’s going on internationally than by the Central Bank itself,” he says.

In other words, volatile imported inflation may be an inevitable function of Iceland’s size and the fact that it has one of the smallest free-floating currencies in the world.

Another reason for the failure of macroeconomic policy to curb inflation, says Íslandsbanki’s Symington, is the preponderance of inflation-related products. “The whole system is shot through with inflation-linked lending,” he says. “That blunts the effect of monetary policy because when rates are raised, it has little effect on the króna in people’s pockets.”

Whatever the ailment, the Icelandic patient seems obdurately resistant to its monetary policy medicine. “The Central Bank’s policy is warranted in the sense that the usual metrics of a slowdown, such as defaults, payment postponements and layoffs simply aren’t there,” says Íslandsbanki’s chief economist, Jón Bjarki Bentsson. “While there has been a slight slowdown in some industrial sectors, the problem for the Central Bank is that this has not yet fed through into the labour or the real estate markets.”

Bentsson says that this is still visible in the strength of demand for new employees in the labour-intensive tourism and construction sectors. This demand, he says, is generally met by imported labour, which in itself is another driver of upward inflationary pressure.

In the housing sector, meanwhile, Jónsdóttir at Landsbankinn says recent indicators suggest the market is heating up in spite of high interest rates. “Twice as many homes were sold in the capital region in April 2024 compared to April 2023,” she says.

That, Jónsdóttir adds, may be due to the loss of about 1% of Iceland’s housing stock as a result of the recent volcanic eruptions in the Reykjanes peninsula, which has prompted the wholesale evacuation of the town of Grindavik.

To date, says Sverrisdóttir at Arion, there has been little evidence that a restrictive monetary policy has stifled growth opportunities in Iceland. The performance of the stock market has inevitably been impacted by the relative appeal of bank deposits, coupled with disappointing company results in the first quarter, many of which were at or below consensus forecasts. By late May, the main Icelandic equity index (the ICEX) was down a little over 2% year-to-date.

But beyond that, the ripple effect of rates close to double digits has been muted. “Loan default rates have risen slightly but are still at pre-Covid levels, so we have yet to see any tangible indication that high rates are having a negative effect on investment,” she says.

The risk to investment levels of restrictive monetary policy is, however, a variable that the Central Bank is monitoring watchfully. “There is a real possibility that with rates at these levels for a longer period of time, investment will be hurt,” says Sverrisdóttir.

That will be a concern if it discourages the development of sectors such as IT and pharmaceuticals that Iceland needs to support its diversification away from tourism.

Visitors from overseas played a decisive role in helping Iceland to recover from its devastating financial crisis in 2008 and the austerity measures that followed. But tourism can be a capricious source of income.

For obvious reasons, this dried up entirely during the pandemic. More specific to Iceland, tourism income is hostage to seismic risk. Paradoxically, the industry benefited extensively from the Eyjafjallajökull volcano in 2010, which acted as a powerful free advertisement throughout the world for Iceland’s unique natural beauty.

The effect of the Grindavik eruptions of 2023 and 2024 has been less benign. Reykjavik-based economists say that in part at least this is a byproduct of misrepresentation by overseas media, which overstated the impact of the volcano on tourists’ safety.

Nevertheless, the closure of one of Iceland’s foremost tourist attractions, the Blue Lagoon hot springs resort, due to its proximity to the eruptions, was inopportune for Iceland as it coincided with the time at which many tourists book their summer holidays.

That is bad news for an industry that has already seen some softening in 2024. “We published a forecast for tourism arrivals in January, and so far, this year arrivals have been below this forecast every month,” says Bentsson at Íslandsbanki. He adds that while he does not expect to see a year-on-year decline in tourist arrivals, growing competition from other Nordic countries is also squeezing tourism income.

The silver lining in a tourism slowdown is twofold. The first is that it may support the Central Bank’s battle against inflation by weakening the labour market. The second is that it may encourage more investment in other, higher value, added spheres of economic activity more suited to a workforce as educated and aspirational as Iceland’s.