Holiday season bump in airfares and imputed rent weigh heaviest

As we had anticipated, international airfares rose 8.0% (0.14% CPI effect), reflecting the demand-driven holiday spike that then reverses in January. Because airfares rose unusually modestly in December 2023, base effects from that small increase cause them to contribute more strongly to this month’s annual inflation rate. In our opinion, though, this month’s rise in airfares is still on the moderate side, as we often see December spikes in the double digits.

Apart from airfares, imputed rent was the main driver of this month’s increase in the CPI. Imputed rent, which reflects owner-occupied housing costs, increased by 0.5% (0.09% CPI effect), whereas we had projected a rise of 0.3%. Although the December measurement is not far from our projection, this makes the second time in a row that it has overshot our forecast, after falling short of forecasts in October. In the months ahead, we expect it to rise by close to 0.5% per month but not break the 1% barrier in the near future But the situation is uncertain, as indicators imply that the rental market is cooling.

Most subcomponents are in line with expectations

Food prices rose 0.3% (0.04%), as we had projected. Closer scrutiny shows that fruit prices fell 2.16% (-0.02%) and the price of vegetables, potatoes, etc. declined 1.07% (-0.01%). The biggest price hikes were in milk, cheese, and eggs, which rose 2.68% (0.06%), as the agricultural pricing committee decided in November to increase both the minimum price paid to farmers for milk and the wholesale price of dairy products, effective 1 December. Coffee, tea, and cocoa rose in price by 0.19%, as harvest difficulties have pushed coffee and cocoa prices sharply higher this year. We do not expect food prices to rise steeply after the turn of the year, and we assume that increases will be broadly in line with those seen in the recent term, as a stronger ISK will help to offset domestic increases. Later in 2025, we expect food prices to rebalance, as most of the effects of higher wage costs and harvest failures have already come to the fore.

The inflation outlook

We expect headline inflation to remain flat in January and then fall quite quickly in February and March. If our forecast is borne out, twelve-month inflation will fall below the upper tolerance limit of the Central Bank’s (CBI) inflation target in March and then draw close to the target itself later in the year.

Our updated preliminary forecast is as follows:

• January – CPI to fall 0.1% (twelve-month inflation 4.8%)
• February – CPI to rise 0.6% (twelve-month inflation 4.0%)
• March – CPI to rise 0.4% (twelve-month inflation 3.6%)

In order for our forecast to materialise, wage drift must be limited and the ISK exchange rate stable. The main uncertainty at present centres on wage agreements for the public sector workers whose contracts are still pending. There is also uncertainty about domestic politics and the global geopolitical situation, as major changes in those arenas could alter the picture significantly.

Gallup’s new inflation expectations survey should provide useful information for the CBI Monetary Policy Committee’s (MPC) February policy rate decision. The survey, conducted in November, suggested that households’ and businesses’ short- and long-term inflation expectations were on the decline. The MPC usually pays close attention to this metric, and as a result, we think a policy rate cut in February is quite likely.