Monetary Bulletin 2026/2

The global GDP growth outlook has worsened since conflict broke out in the Persian Gulf at the end of February. For Iceland’s main trading partners, GDP growth is projected to slow from 1.9% in 2025 to 1.4% this year. The global inflation outlook has deteriorated as well, especially for the short term, due to the surge in energy and other commodity prices. Central banks in major advanced economies have held policy rates unchanged thus far but are likely to raise them as the year advances.

In Iceland, GDP growth measured 1.3% in 2025, as was forecast in February. It is expected to have been stronger in Q1/2026 than was forecast, but the outlook for the year as a whole has deteriorated. Year-2026 GDP growth is now projected at 1.6%, or 0.4 percentage points below the February forecast. The poorer outlook is due primarily to weaker growth in domestic demand. The contribution of net trade to output growth is broadly unchanged, however, although prospects for tourism later in the year have dimmed. The outlook is also for weaker economic activity in the latter half of the forecast horizon, with GDP growth averaging 2% per year in 2027 and 2028.

It appears that labour market activity is continuing to lose pace. Job creation has stalled and unemployment risen. Firms’ hiring plans have eased, which indicates a softening labour market in the coming term. The slack that opened up in the economy in late 2025 is forecast to be markedly wider this year than previously estimated. As before, it is expected to persist over the forecast horizon.

Inflation has risen year-to-date, measuring 5.2% in April. Although the rise in inflation stems partly from the direct impact of oil price hikes caused by the conflict in the Persian Gulf, domestic inflation is high as well. Underlying inflation has increased to 4.4% as of April, after having measured around 4% for most of 2025. Short-term inflation expectations have also risen, while long-term expectations have changed less markedly. The inflation outlook has worsened, as global inflation looks set to be higher and growth in unit labour costs to be stronger over the next two years. This will be offset by a larger slack in the economy. Inflation is projected to fall below 4% in mid-2027 and realign with the target at the beginning of 2028.

The global economic outlook has grown more uncertain once again, owing to the conflict in the Persian Gulf and its implications for, among other things, prices and supplies of oil, jet fuel, and commodities. Economic developments will depend to a large extent on how long the war lasts and how quickly energy production and traffic through the Strait of Hormuz can be returned to normal. If oil prices increase more than is assumed in the baseline forecast, inflation could rise higher and economic activity could be slower. Developments will also depend on how the trade dispute between the US and other countries evolves. Furthermore, there is uncertainty about domestic wage developments over the forecast horizon. The baseline forecast assumes that the review clause in wage agreements will be activated in August but that contracts will not be terminated. However, if they are terminated and larger pay hikes are negotiated, economic activity could be dampened further and inflation could turn out even more persistent than is depicted in the baseline forecast.