OECD Economic Outlook, Volume 2025 Issue 1

Iceland

GDP growth is set to recover to 1.4% in 2025 and 2.8% in 2026, driven by household consumption and the rebound of exports. Business investment will be strong in 2025 but weaken in 2026 as several projects will end. Unemployment will edge up, but the labour market remains tight. Major risks include a violent volcanic eruption and further tariff escalation affecting Iceland’s main export goods.

In May, the central bank cut the policy rate to 7.5%, the fifth cut since monetary easing started in October 2024. Inflation has fallen to around 4% and is expected to reach the target by the second half of 2026. The new government has committed to a tight fiscal stance over the next two years, which will help underpin disinflation and build up fiscal space. Reforming the fiscal framework and business regulation will help increase stability and sustainability of the public finances and foster productivity, investment and growth.

Economic growth has likely bottomed out

Economic growth has slowed against the backdrop of tight monetary policy but seems to have passed its low point. Household consumption is expanding gradually, driven by growing real wages following the 2024 agreements and rising consumer confidence. The wage agreements of 2024 imply wage increases of over 6% per year including wage drift. Business investment has begun to recover from the downturn in the second half of 2024 as financial conditions eased. Despite slowing population growth, investment in housing remains substantial, supported by rising incomes. Exports have rebounded, particularly in the fisheries sector, which benefits from increased catch quotas. The unemployment rate has risen slightly from around 3.5% at the end of 2024. Volcanic activity on the Reykjanes peninsula has had minimal impact over the past six months. Various inflation measures have declined sharply, but annual headline inflation, at 4.2% in April, is still well above the 2.5% target.

Iceland

1. Year-on-year growth rates. The sum of components may deviate from observed GDP growth because of balancing items, chain-linking procedures and direct/indirect seasonal adjustment methods.

Source: OECD Economic Outlook 117 database; Statistics Iceland; and central bank of Iceland.

Statlink

Iceland: Demand, output and prices

Statlink

Following a sharp increase of imports, notably of computer equipment for new data centres, the current account balance and the net export contribution to growth have turned negative. Icelandic goods are subject to a general 10% US import tariff. The additional increase in US tariffs on aluminium imports from 10% to 25% in March has had little effect so far, as Iceland does not export aluminium to the United States.

Monetary policy is easing, while fiscal policy remains contractionary

The central bank began easing monetary policy in early autumn 2024 and has cut the key interest rate to 7.5% by May 2025. It is projected to be lowered further throughout 2025 and more gradually thereafter, to around 5% by end-2026. The trade-weighted exchange rate has appreciated since early 2025, largely due to a weaker USD. Fiscal policy, as indicated by the underlying primary balance, will be tightened further by approximately 1.4% of GDP in 2025 and 0.6% in 2026. These measures will help alleviate inflationary pressures and build fiscal space. Gross public debt will decline further as the government-owned Housing Financing Fund is wound down.

The economy is set to recover gradually

The economy is projected to grow by 1.4% in 2025 and 2.8% in 2026. Private consumption will expand, driven by real wage increases. Residential investment will remain robust, supported by improving financial conditions and sustained housing demand. Business investment is projected to grow as confidence rises and financial conditions continue to ease. Export growth will be broad-based but moderate as foreign tourism will expand modestly, while aluminium production remains largely unaffected by higher tariffs with smelters operating at full capacity. The unemployment rate will rise to above 4% in 2025 and stabilise thereafter. Inflation is expected to continue to decline in the face of still tight macroeconomic policies but to stay above target until mid-2026. However, it could exceed expectations if import prices, especially for food and oil, begin to rise again. Escalating trade tensions could strangle goods exports and dent tourism if disposable incomes decline in the countries raising tariffs. Volcanic activity on the Reykjanes peninsula and near the capital area could cause further infrastructure damage and require additional public relief spending.

Reforming the fiscal framework would strengthen public finances

Replacing the current budget balance rule with a structural spending rule could mitigate pro‑cyclical fiscal policy, enhancing the stability and sustainability of public finances. The introduction of resource taxes, including the planned reform of fishing fees and the implementation of a new visitor tax, will support the sustainable management of natural resources. Eliminating exemptions in the value-added tax, particularly by reinstating the standard VAT rate on tourism services, will reduce distortions within the tax system. Lowering barriers to market entry will encourage investment. Easing the licensing and permit system for various professions and accelerating further the recognition of foreign diplomas will help to boost productivity and alleviate labour shortages.