Real wages fell by 0.3% MoM in June but have risen by 4.0% in the past twelve months. Real wage growth has been robust in the recent past; for instance, YoY growth measured 4.1% in Q2/2020, its strongest in just over two years — something of a surprise, given the brisk headwinds jostling the economy in the recent term.

This growth is due mainly to the so-called Living Standards agreements, plus subsequent agreements made on similar terms, which have delivered sizeable proportional pay hikes to large groups of workers since spring 2019. At the same time, inflation has remained modest, despite a 7% depreciation of the ISK in the interim. This is a new twist in Iceland’s economic history, and in our opinion, it bears witness to, among other things, the increased credibility of the Central Bank (CBI) and more effective competition in the retail market than in the past.

Making hay while the sun shines builds stores for the winter freeze

There is a reasonably strong long-run correlation between developments in private consumption and real wages. Sometimes, however, the connection between the two has ruptured. A good example of this is the private consumption boom from 2004 through 2007, which was financed largely through increased household borrowing. Then, when the financial crisis steamrolled Iceland in H2/2008, private consumption shrank much more than real wages did, as most households were dealing with very tight balance sheets at the same time. Fortunately, such leveraged consumption has not been a prominent feature in recent years, and Icelandic households will surely feel the benefits of this increased caution during the current recession.

Real wages or jobs?

But private consumption is governed by more factors than real wages alone. Other determinants include asset prices and their impact on household wealth, consumer expectations about the economic outlook, population growth, interest rates (which can make saving either more or less attractive than consumption at any given time), and finally, the employment level. When unemployment rises, jobless consumers’ disposable income falls sharply, as unemployment benefits are below even the lowest wages. As a result, some share of the contraction in private consumption a decade ago must have been due to the spike in unemployment. According to SI figures, the jobless rate rose to a temporary high of around 9% in spring 2009 and did not find a new equilibrium until the middle of the 2010s.

In coming quarters, the interaction between unemployment, real wages, and private consumption will probably diverge substantially from Iceland’s usual pattern in a contraction. Until now, the tendency has been for an ISK depreciation to put an end to the upward cycle, triggering an inflation spike and modest nominal wage hikes, which in turn temporarily erodes real wages.

This time, though, it appears that real wages will be able to stare down the COVID shock fairly effectively. The macroeconomic forecast issued by ÍSB Research in May provides for real wage growth of just over 2% in 2020, followed by an annual average of 1.5% in 2021 and 2022. As in the recent past, this real wage growth is attributable to the interaction between handsome contractual pay rises and modest inflation.

Unfortunately, though, the unemployment rate looks set to remain considerably higher in the coming term than it was following the 2008-2009 crisis. In large part — and particularly in the immediate future — this is simply because of the suddenness of the current shock and its direct aim at the very labour-intensive tourism sector. Nevertheless, it can also be said that, instead of being spread more or less evenly across the labour market, as has typically been the case following past inflation spikes, the current episode is likely to have a split impact on two groups:

Those still employed will enjoy real wage growth similar to that in the recent past, and the growing group who have lost their jobs will suffer a significant drop in disposable income and will therefore probably bear the brunt of the economic crisis to a greater degree than they would have previously. Persistent and widespread unemployment is the curse of many economies at the moment, bringing with it a loss of human capital, a deterioration of living standards, an increase in social problems, and civil unrest, to name just a few side effects. Here in Iceland, however, we have been able to avoid many of these ills until now. As a result, the social partners are faced with a genuine and weighty dilemma: should we continue on the path already staked out, or should we prioritise employment over real wage growth until the economy rights itself again?