Monetary Bulletin 2025/3

The GDP growth outlook for Iceland’s main trading partners has improved slightly since the May forecast. In Q1, growth was marginally stronger than in the forecast, measuring an average of just over 1.8%. It is also expected to be stronger in Q2. However, GDP growth is still expected to subside as the year advances, owing to the trade war and continued global trade uncertainty. The global inflation outlook is slightly improved as well, although inflation is still expected to rise in the near future because of the trade war, especially in the US. Central banks in major advanced economies have continued to cut policy rates in tandem with lower inflation and a bleaker economic outlook.

According to revised figures from Statistics Iceland, domestic GDP contracted by 0.7% in 2024, whereas previous figures had indicated 0.5% growth. In part because of this change, Q1/2025 GDP growth turned out stronger than had been assumed in May. Indicators imply continued robust GDP growth in Q2, with stronger growth for the year as a whole than was forecast in May, or 2.3% instead of 1%. The deviation is due in particular to base effects from reduced activity in 2024 and more rapid growth in domestic demand, owing mainly to stronger-than-expected investment growth. The output growth outlook for 2026 and 2027 is broadly unchanged.

Indicators from the labour market imply that demand pressures continued to ease in Q2. Unemployment has held broadly unchanged recently, however, and is expected to average 4.4% this year and then start falling in 2026. Job vacancies continue to decline in number, and population growth has slowed. Demand pressures in the economy therefore continue to ease, but at a slower pace than was forecast in May.

Inflation averaged 4% in Q2/2025, as opposed to the May forecast of 3.9%. It measured 4% in July and eased between months. Underlying inflation measured 3.9% and, like measured inflation, has remained broadly flat recently. Market agents’, households’, and businesses’ inflation expectations were also largely unchanged between surveys. As was forecast in May, inflation is expected to pick up again, to 4.5% in Q4, which is somewhat above that forecast, owing mainly to a poorer initial position. It is expected to be somewhat higher in the early part of the forecast horizon than was assumed in May. It is still expected to measure 3% at the end of 2026 and reach the target in H1/2027.

Although uncertainty about world trade and economic activity has receded since May, it remains pronounced, and developments will depend in large part on the scope and form of the tariff hikes implemented by the US administration, which have proven unpredictable. In Iceland, however, there is greater uncertainty about the impact of new tariffs on Icelandic goods exported to the US and the possibility of tariffs on ferro-alloys and ferrosilicon exports to the EU. Furthermore, there is continued uncertainty about developments in the wars currently ongoing. There is mounting concern about how slowly domestic inflation has fallen in the recent past, and it is clear that poorly anchored inflation expectations have made it more difficult to bring inflation under control.