The anti-establishment Pirate Party, in alliance with the left-wing Green Left, will likely head the next Icelandic government following early elections in the autumn of 2016. This government will likely lead an expansionary fiscal policy course, with negative consequences for the economy, and will be extremely unstable, raising the possibility of another round of early elections soon thereafter.
Iceland's economic rebound will remain in place in the coming quarters, driven predominantly by private consumption, which will be boosted by rising wages and improving house prices. Recent positive high-frequency indicators have prompted us to revise upward our forecast for real GDP growth in 2016 and 2017 to 4.2% and 3.5%, respectively.
We expect inflation In Iceland to rise back within the central bank's 2.5% target by year-end, bolstered by rising demand-side inflationary pressures and FX weakness due to the ongoing lifting of capital controls. Rising inflation will allow the monetary authorities to hike interest rates as early as H216 to 6.50% from 5.75% at the time of writing.
The biggest risk to our forecast is policy trajectory, particularly in terms of how the current government chooses to remove distortive capital controls. Mishandling of the capital account liberalisation process has the potential to trigger a sell-off in the krona, Similarly, taking a hard stance with regards to capital withdrawals by foreign creditors could damage long-term investor sentiment towards Iceland.
|Real GDP growth, % y-o-y||1.9||4.1||4.2||3.5|
|Nominal GDP, USDbn||16.3||15.1||14.4||15.8|
|Consumer price inflation, % y-o-y, eop||0.8||2.0||3.0||2.5|
|Exchange rate ISK/USD, eop||127.51||130.10||150.00||142.86|
|Budget balance, % of GDP||-0.2||0.0||0.1||0.1|
|Current account balance, % of GDP||4.4||3.2||2.1||0.9|
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