The July measurement is below our forecast. We had projected that the CPI would increase by 0.2% MoM, and other forecasters were broadly in agreement. Expectations changed somewhat, however, with the Housing and Construction Authority’s publication of the capital area house price index for June, which showed that house prices in greater Reykjavík had fallen 1.1% month-on-month. The main difference between our forecast and SI’s measurements lies in imputed rent, which declined despite our expectations. On the other hand, airfares rose more than we had anticipated, and the effects of seasonal sales on the price of furniture, housewares, and electronic equipment were negligible.

Sudden about-face in house prices

The CPI item that probably took most observers by surprise in July was imputed rent, which largely reflects the market price of housing. This month, imputed rent declined by 0.7% MoM (-0.14% CPI effect), including a 1.3% drop in the market value of residential housing, whereas the interest component, which reflects indexed mortgage rates, increased by 0.6%. Paid rent, on the other hand, rose by 0.8% MoM (0.03%), and households’ heating and electricity costs increased by 2.4% (0.08%).

The MoM drop in the market price of housing was the largest since the beginning of 2011. All subcomponents of housing market prices declined between months, led by prices in regional Iceland, which fell 2.8%. In greater Reykjavík, condominium prices fell by 0.7% MoM, while single-family home prices fell 0.8%.

It goes without saying that the housing market has turned a corner this year. Twelve-month house price inflation has fallen to a four-year low of 3.8%, after peaking at nearly 25% a year ago and measuring 18.2% at the beginning of 2023. Capital-area condominium prices are now up 2.0% year-on-year, single-family home prices have risen 6.5%, and prices in regional Iceland are up 6.1% in the past twelve months.

We view this turnaround as a clear sign that the Central Bank’s (CBI) policy rate hikes and more stringent lending requirements have begun to have a significant impact on demand, and thereby on the economy more broadly. At the same time, the housing supply has grown markedly, and other measures of market activity – such as the average time-to-sale and the share of properties selling above the asking price – show clearly that tensions in the housing market have eased in the past year. We think it likely that the market will maintain its current pace in the near future and that prices will keep pushing headline inflation downwards.

Weaker-than-expected sale effects in July

Seasonal sales generally affect prices in July, but this time they defied our expectations somewhat, not least because of the 8.7% drop in clothing and footwear prices (-0.34% CPI effect). Furniture and housewares prices fell marginally (-0.03% CPI effect), whereas items such as television sets, computers, and stereo equipment rose in price. Seasonal sales on these last items may well affect the August CPI measurement.

Travel costs pick up in mid-summer

The peak tourist season is now in full swing, and as in the past, the July CPI measurement shows it. Airfares rose by 12.5% (0.27%) MoM, and the price of hotel and restaurant services by 1.2% (0.06%).

Other inflationary items included motor vehicle prices and various costs of car operations, which pushed the CPI upwards by 0.04%. Petrol prices fell by 1.1% in July, however, lowering the CPI by 0.03%.

And finally, food prices rose 0.44% during the month (-0.06%), the smallest MoM decline since September 2022. The main determinant here was the virtual standstill in imported food prices, while goods produced primarily in Iceland – meat, fish, and dairy products – accounted for almost all of the MoM increase.

The composition of inflation has changed considerably since the decline started last spring. This February, when inflation peaked at 10.2%, imported goods accounted for some 28% of the headline figure, the housing component nearly another third, domestic goods just over 17%, and services around 22%.

The composition of inflation has changed considerably since the decline started last spring. This February, when inflation peaked at 10.2%, imported goods accounted for some 28% of the headline figure, the housing component nearly another third, domestic goods just over 17%, and services around 22%.

In July, however, imported goods contributed 23%, the housing component 30%, domestic goods 20%, and services prices 28%. Domestic goods and services prices therefore explain a noticeably larger share of overall inflation at present, while the contribution from imported goods and the housing component has receded. This trend aligns well with our expectations from earlier this year: that imported inflation and house price inflation would ease later in 2023, while inflation rooted in domestic costs could prove more difficult to dislodge.

The H2/2023 inflation outlook has improved

In view of recent developments in house prices, we have updated our preliminary inflation forecast for the near term, as the housing component looks set to continue to dampen inflation. A portion of this summer’s sale effects (housewares, electronic equipment, etc.) will probably shift to the August CPI measurement, while end-of-sale effects should show mainly in September, as they have in the past.

According to our preliminary forecast, the CPI will rise 0.1% in August. 0.4% in September, and 0.3% in October, leaving headline inflation at 7.4% in October. Inflation looks set to measure around 7% at the end of the year. The outlook has for the second half has therefore improved.

Bond market responds positively to inflation figures

Following the publication of the July inflation figures, Fridays’s market responses reflected a certain change in market agents’ expectations about inflation and interest rates. Nominal Treasury bond yields fell by between 3 and 24 basis points, while most indexed Treasury yields rose. The breakeven inflation rate in the bond market has therefore fallen. The spread between nominal and indexed Treasury yields currently reflects an average long-term breakeven inflation rate of approximately 4%, although this also includes an uncertainty premium. As a result, market agents’ long-term inflation expectations are somewhat below this figure.

The disinflation of the past few months must be welcome news for the CBI, after the struggles of the past winter and spring. The bank’s next policy rate decision is scheduled for 23 August, so the July inflation measurement will be the most recent the Monetary Policy Committee (MPC) will have in hand. Other things being equal, recent inflation developments should discourage the MPC from pushing the policy rate much higher, especially if members take into account developments in payment card turnover and other statistics showing that Icelandic households have begun to ease their consumption spending.