Housing component still the main driver

As in recent months, the housing component is the main catalyst of inflation. Imputed rent rose by 0.9% (0.17% CPI effect), and heating and electricity costs rose 3.3% (0.11%), whereas we had forecast that imputed rent would rise by 0.5% (0.10%). The oft-mentioned new method for calculating owner-occupied housing costs (imputed rent) has thus far led to much lower twelve-month inflation than would have been measured using the old method. Actually, headline inflation would have been about one hundred basis points higher if the methodology had not been changed in June.

Interpreting the past few months’ movements in imputed rent can be a complicated business. Signs of rental market tightness are more readily visible, while the rise in imputed rent has been less pronounced than indicators had implied. This is because the indicators can be found in hikes in new rental leases, whereas imputed rent measurements include increases in all valid leases apart from non-profit contracts. Because of this, rises due to new leases are slower to affect inflation measurements, as only a small share of current leases expire and are replaced by new contracts in any given month. The rise in this component is therefore due in large part to price indexation of the majority of leases, although that rise is undeniably a large one.

The new imputed rent calculation method has been accompanied by reduced month-to-month volatility thus far, but we had expected fluctuations to be even smaller than they have turned out. The August increase in imputed rent is therefore likely to stem from indexation rises in current leases. It is also possible that a larger number of rental agreements that affect inflation measurements expired in August than has been the case in most other months.

One-off items pull inflation downwards

The main items pulling inflation downwards in August are a 21.1% drop in university fees (-0.14% CPI effect) and a 7.1% decline in international airfares (-0.17%). Changes in school fees generally take effect in August and therefore have a once-yearly impact on the CPI. This year’s decline was due to the cancellation of fees at several of Iceland’s universities. According to SI’s press release, the effects of school meal subsidies will show in September, thereby leading to a decline in primary school expenses in the CPI.

It is noteworthy that food and beverage prices fell by 0.5% during the month (-0.07% CPI effect), whereas we had projected an increase of 0.5% (0.07%) The decline – the first MoM drop in food prices in three years – is probably due to the new grocery store that has entered the market. It is possible that food prices will fall further in coming months, as the new store in question had not opened at the time August measurements were taken, and the downward effect on the September CPI was probably underestimated.

Tepid end-of-sale effects

The end of seasonal sales had a more muted impact than we had expected. Summer sales were relatively shallow this year, although various items fell in price in both June and July. As a result, we had expected modest end-of-sale effects, but they turned out even gentler than we had anticipated: clothing and footwear prices rose 1.78% (0.06% CPI effect), and furniture and housewares prices rose 1% (0.06%). End-of-sale effects could stretch over August and September, however, and next month we could see another rise in clothing and footwear prices like that in August, plus a slight uptick in the price of furniture and housewares. Electronics stores were still in summer sale mode, however, with prices down 3.74% in August (-0.06%).

Market responses

Thus far today, the breakeven inflation rate in the bond market has fallen considerably, particularly at the shorter end of the yield curve. The three-year breakeven rate is down 35 basis points, the five-year rate has fallen 25 basis points, and the ten-year rate is down 20 basis points. This will certainly give cause for cheer among members of the Central Bank’s Monetary Policy Committee, who have repeatedly said that inflation expectations must fall before monetary easing can begin.

The near-term outlook

In line with this morning’s figures, we have revised our preliminary inflation forecast for the next few months slightly downwards, although we think the short-term outlook is broadly unchanged. According to our preliminary forecast, we expect the following MoM movements in the CPI:

• September – CPI to rise 0.2% (twelve-month inflation 5.8%)
• October – CPI to rise 0.2% (twelve-month inflation 5.4%)
• November – CPI to rise 0.3% (twelve-month inflation 5.3%)

Uncertainties in the coming term

There are still a number of uncertainties, including the effects of the new imputed rent calculation method. In this case, uncertainty has mounted due to this month’s steep rise in imputed rent and to greater initial month-to-month volatility than we had expected. The outlook is for a further decline in food prices in coming months, but this creates uncertainty about potential price hikes during the winter. It is worth noting, however, that the price of food and beverages has risen steeply in recent months. The main uncertainty for coming quarters pertains to the cancellation of fuel taxes at the turn of the year. All else being equal, and assuming that the taxes levied to replace them are not earmarked, the CPI will drop sharply in January.

In order for our forecast to materialise, wage drift must be limited and the ISK exchange rate stable. As before, the ongoing wars in various parts of the world are another uncertainty, and any escalation on that front will affect cross-border trade, prices, and economic developments in Iceland and abroad.