Iceland

Following an impressive recovery from shocks in recent years, tight monetary and fiscal policies have slowed domestic demand growth, strengthened the current account, and started to lower inflationary pressures.Real GDP grew by 4.1 percent in 2023 but slowed considerably through the year and into 2024 as high inflation reduced real disposable income growth and weakened private consumption, while the increase in the cost of capital weighed on private investment.After operating significantly above potential in early 2023 slack in the economy is now increasing, contributing to a decline in inflation to 6.2 percent in May 2024 from a peak of 10.2 percent in February 2023.Growth is expected to decline to 1.2 percent in 2024 on further softening domestic demand and decelerating growth in tourism spending, before recovering to 2.4 percent in 2025.Inflation is projected to decline to 5.1 percent by end-2024 and 2.6 by end-2025 on tight macroeconomic policies.The current account is projected to gradually strengthen, including from an increasing contribution from pharmaceutical exports. Executive Board AssessmentIn concluding the 2024 Article IV consultation with Iceland, Executive Directors endorsed the staff's appraisal, as follows:A coordinated tightening of macroeconomic policies has successfully narrowed domestic and external imbalances built up during the post-pandemic period.The economy was operating above capacity in 2022 and early 2023, but decelerated significantly since mid-2023 and the output gap is now closing.The ongoing volcanic activity on the Reykjanes peninsula has disrupted lives and livelihoods, but its broader economic implications are expected to be limited.1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year.A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies.On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.2 Management has determined it meets the established criteria as set out in Board Decision No. 15207 (12/74);(i) there are no acute or significant risks, or general policy issues requiring a Board discussion; (ii) policies or circumstances are unlikely to have significant regional or global impact in the near term; and (iii) the use of Fund resources is not under discussion or anticipated.©International Monetary Fund.Not for RedistributionAppropriately tight macroeconomic policies are expected to dampen economic growth in the near term, while medium-term growth prospects are favorable.Growth is expected to decline in 2024 before increasing in 2025 on the back of a gradual easing of the monetary policy stance.Inflation is projected to reach the 2.5 percent inflation target in first half of 2026.Medium-term growth prospects remain favorable, driven by an expansion of innovation-based sectors and migrant labor inflows.Risks to the outlook are broadly balanced.The authorities' fiscal targets are broadly appropriate, though additional measures are required to achieve the planned medium-term consolidation.The broadly neutral fiscal impulse this year is warranted given the narrowing of economic imbalances and spending associated with the volcanic activity.The envisaged medium-term fiscal consolidation is consistent with a gradual increase in fiscal space to prepare for future shocks, but will require additional measures over the next five years, which could include reducing the number of items subject to reduced VAT rates, streamlining tax expenditures and incentives, and increasing the taxation of realized capital gains on second homes and investment properties, as well as further spending measures.Public debt is on a downward path and resilient to shocks.Reactivation of the fiscal rules in 2026 presents an opportunity to revisit their design to ensure fiscal policy is both sustainable and contributes to macroeconomic stability.To reduce procyclicality and bolster the sustainability of fiscal policy, the authorities should consider replacing the current overall balance rule with a limit on government spending.Increasing the resources of the Fiscal Council and strengthening its mandate would help support the support the credibility of the fiscal rules.The CBI should lower the policy rate as inflation declines.The monetary policy stance remains appropriately tight given still elevated inflation and inflation expectations.It should be eased toward the estimated neutral real rate once headline inflation and inflation expectations fall inside the 1-4 percent notification band and there is clear evidence that inflation will return to target. An application of the IMF's Integrated PolicyFramework to Iceland suggests some benefits of foreign exchange interventions during times of stress.Iceland's shallow foreign exchange markets create a risk of disruptive exchange movements during times of stress.In these circumstances, foreign exchange intervention can reduce the burden on monetary policy and help cushion the impact of the shock.The CBI should seek opportunities to increase reserves to strengthen its ability to prevent disruptive exchange rate movements.The authorities should also explore options to deepen the foreign currency derivatives market in a manner consistent with continued foreign exchange market stability.©International Monetary Fund.Not for