Trading partner GDP growth measured 1.9% in Q4/2024, its highest in about two years. The February forecast assumed that it would pick up this year, but now it is expected to be weaker than in 2024, and 0.4 percentage points lower than was projected in February. The revision is due mainly to the US trade war and its harmful effects on world trade and economic activity. The global inflation outlook has also deteriorated since February because of the tariff hikes.

In Iceland, GDP growth measured 0.5% in 2024, outpacing the February forecast, primarily because Statistics Iceland revised GDP growth figures for the first three quarters of the year. Domestic demand grew over the course of 2024, driven partly by increased investment but offset by a negative contribution from net trade. GDP is estimated to have increased marginally year-on-year in Q1/2025, and output growth for the year as a whole is projected at 1%, or 0.6 percentage points below the February forecast. The poorer outlook is due largely to base effects from stronger activity in 2024 and the adverse effects of the trade war, although increased private consumption growth pulls in the opposite direction. As in February, GDP growth is projected to gain momentum over the next two years, although it will be slightly weaker than was assumed then.

Indicators imply that the domestic labour market will continue to cool. Job numbers fell marginally in Q1, and unemployment has continued to inch upwards. Unemployment is projected to average 4.7% this year and then start falling in 2026. Because of Statistics Iceland’s revision of year-2024 GDP growth figures, the positive output gap is larger than previously thought, and an output slack will open up later than was assumed in February.

Inflation eased in Q1 but ticked upwards again in April, to 4.2%. Underlying inflation rose as well, reaching 4%. Inflation expectations are still above target, although the May survey indicates that market agents’ long-term expectations have fallen to about 3%. Inflation is expected to taper off to 3.8% in Q3 but will be somewhat above the February forecast in the quarters ahead, primarily because of a poorer initial position. It is also assumed to be a bit higher in 2026, mainly because the slack in the economy will be slightly narrower. Pulling in the other direction is the prospect of a somewhat stronger króna than was forecasted in February. The effects of the trade war on inflation are assumed to be small. Inflation is forecast to reach the target at the beginning of 2027, somewhat later than was projected in February.

Global economic uncertainty has surged in the wake of the trade war that started earlier this year. The baseline forecast assumes that the trade war will lead to slower growth in investment and services exports and that GDP growth will be weaker in 2025 and 2026 than it would have been otherwise. The impact the trade war will have on the domestic economy is highly uncertain, however, and the global economy could be even more strongly affected than is currently assumed if the dispute intensifies still further. To a large extent, the impact on domestic inflation will depend on whether the trade war affects demand more than supply, or vice versa. Weakly anchored inflation expectations and prolonged cost increases could cause the effect on inflation to be stronger and more persistent than is assumed in the baseline forecast.