Monetary Bulletin 2025/4

Global economic activity has proven more resilient than was expected earlier in the year. Trading partner GDP growth measured 1.8% in Q2 but is still expected to soften in H2, owing to US tariff hikes and the uncertainty they have caused. The outlook further ahead is broadly unchanged, however, and GDP growth is still projected at 1½% throughout the forecast horizon. Trading partner inflation has picked up again in the recent term, but the global inflation outlook for the next few years is more or less unchanged.

GDP growth in Iceland measured 0.3% year-on-year in H1, well below the forecast in the August Monetary Bulletin. Furthermore, Statistics Iceland has revised previous year-2024 GDP figures, which now suggest that GDP contracted by 1% year-on-year. GDP is also estimated to have shrunk in Q3/2025, and growth for the year as a whole is projected at only 0.9%, as compared with the August forecast of 2.3%. The outlook for 2026 has deteriorated as well, owing largely to recent shocks to Iceland’s export sectors. GDP growth is projected at 1.6% in 2026, or 0.5 percentage points below the August forecast. Prospects for the latter half of the forecast horizon are broadly unchanged, however: GDP growth is expected to average 2½%,
well in line with potential output.

Labour market tightness has clearly eased. Population growth and job creation have slowed markedly, and unemployment has inched upwards. Unemployment is projected to average 4½% in 2026 but start to taper off in H2. Economic activity appears to have reached a turning point. It is now estimated that the 2024 output gap was slightly smaller than previously assumed, and that a slack is opening up in H2/2025 and will persist for most of the forecast horizon.

Inflation measured 4.3% in October and has risen by 0.3 percentage points since July. Underlying inflation has crept upwards as well. Inflation expectations are still above target and have changed little in the recent past. Although the recent uptick in inflation was anticipated, inflation turned out slightly lower in Q3 than was forecast in August. Owing to a more favourable initial position, the near-term inflation outlook has improved. In addition, the slack in the economy is estimated to be larger than previously expected, albeit offset by a lower exchange rate. Inflation will therefore fall more rapidly than previously forecast; it is expected to reach 3½% around mid-2026 and align with the target in early 2027.

Although uncertainty about the US administration’s stance on tariffs has abated, it is still pronounced, and the impact of the tariffs on world trade is unknown. Furthermore, activity in the domestic economy has subsided more quickly than previously envisioned, while inflation has remained stubbornly high. It is therefore uncertain how rapidly inflation will fall back to target. If the effects of weakly anchored inflation expectations and recent cost hikes are underestimated, inflation could fall more slowly than is forecast. On the other hand, inflation could prove lower if recent export shocks and mortgage market turbulence result in a larger slack in the economy, but there is considerable uncertainty about how changes in the loan supply will affect households’ financial conditions.