Arion Bank’s new eco­nomic fore­cast: A long win­ter, a slow thaw

Arion Bank’s new economic forecast assumes that winter will be long for the Icelandic economy and that the spring thaw will be late in coming. There is no end in sight to the war in the Middle East, with repercussions for energy markets, inflation and growth both in Iceland and abroad. Hopes of swift interest rate cuts have faded, and households and businesses have become more pessimistic. These challenges are reflected in a lower growth forecast, higher interest rates and higher inflation. 

Inflation has proved harder to contain than previously expected. Persistent domestic inflationary pressures cannot be overlooked, but the main forces pushing inflation higher have been the war in the Middle East and increases in public levies. We expect inflation to ease next year, partly thanks to base effects, averaging 4.2%. The path to the inflation target remains difficult, however, delaying rate cuts until the middle of next year. Our forecast puts the policy rate at 7% by the end of next year, a reduction of one percentage point. 

Although households carry little debt and their financial position is generally strong, high interest rates, a high cost of living and rising unemployment have dampened their expectations.  Together, these factors are expected to curb spending appetite and private consumption growth this winter and well into next year. High interest rates and tighter credit conditions also shape the investment outlook, particularly residential investment, which is expected to contract this year and more sharply next year. We forecast continued weakness in the housing market and falling real house prices until mid-2028. 

Data centres have driven fluctuations in the national accounts, with substantial imports of computer equipment this year while exports have contracted slightly. All export components are expected to contribute to growth next year, including tourism, fisheries, aluminium, aquaculture and data centres. Together with lower imports, this will give net trade a positive contribution to GDP growth. The króna has been strong and is expected to remain so, despite the pressure this places on export industries. 

The outlook is more clouded than usual, with commodity prices moving rapidly, fragile international relations and tensions in the labour market. Whatever happens, we believe the economy rests on solid foundations and that spring will return, even if the thaw is slow to arrive.