OECD Economic Outlook, Volume 2025 Issue 2

Iceland

GDP growth is set to increase from 1.1% in 2025 to 1.6.% in 2026 and 3.6% in 2027, driven by robust private consumption and a rebound of exports. Business investment growth will decline from a high level. The unemployment rate will edge up above 4%, but the labour market will remain tight. Inflation currently hovers around 4% and is expected to reach the target by the second half of 2026. Major risks include a violent volcanic eruption and further tariff escalation affecting Iceland’s main export goods.

The central bank is expected to continue lowering the policy rate in early 2026 and cut it further until it reaches around 5% in 2027, which is appropriate. Fiscal policy is tight and set to remain so over 2026-27, which will help underpin disinflation and build up fiscal space. Reforming the stringent regulatory framework and fostering competition will strengthen business dynamism and raise productivity.

Growth remains sluggish

Activity remains subdued amid persistently tight monetary policy and elevated global uncertainty. Export growth is held back by several shocks in late 2025, among them the failure of an electric interconnector at a large aluminium plant and the bankruptcy of a low-cost airline. Private consumption is recovering only gradually, constrained by fragile and volatile consumer sentiment despite a steady increase in real wages. After strong growth in the second quarter of 2025, business investment is weakening as demand for AI‑related infrastructure and equipment has reached a peak. Housing investment has moderated, reflecting slowing population growth and restrictive financial conditions. The unemployment rate has started to rise, although the labour market remains tight overall. Headline consumer price inflation remains high at around 4%, significantly above the 2.5% target. It is driven primarily by food and domestic service prices, with the contribution from housing gradually diminishing.

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 118 database; Statistics Iceland; and Central Bank of Iceland.

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Iceland: Demand, output and prices

Statlink

The external balance continues to deteriorate, reflecting sustained import demand, particularly for data centre-related capital goods sourced from abroad. As a result, both the current account balance and the net export contribution to growth have turned increasingly negative. Since August 2025 Icelandic exports face a general 15% import tariff from the United States, especially affecting seafood exports. The increase in US tariffs on aluminium imports from 10% to 25% in March and 50% in June triggered a sharp, albeit temporary decline in global aluminium prices. While Iceland does not export aluminium directly to the United States, the price shock has weighed on export revenues.

Macroeconomic policy will remain tight

The central bank has reduced its policy rate from 9.25% in September 2024 to 7.25% by November 2025. Given the slowing pace of disinflation, with inflation expected to reach the target by mid-2026, further rate cuts are projected to restart in early 2026. The trade-weighted exchange rate has appreciated since summer 2025, largely due to a weaker US dollar. Fiscal policy is set to tighten further, with the underlying primary balance improving by 1.2% of GDP between 2025 and 2027, primarily through better tax collection. Fiscal tightening will support disinflation and broaden fiscal space.

The economy will rebound gradually

The economy is projected to grow by 1.6% in 2026 and 3.6% in 2027. Private consumption will strengthen, underpinned by continued gains in real wages. Exports are projected to remain weak through to late 2026, reflecting lower fishing quotas but are expected to strengthen thereafter as production at the aluminium plant resumes. Residential investment will rebound as financial conditions ease and disposable income rises, despite a Supreme Court ruling prohibiting indexed mortgages. Business investment growth will moderate, as demand for computer equipment will weaken further. Consequently, capital goods imports will also decline. The unemployment rate will edge up above 4% by 2027. Headline inflation is projected to decline in the face of still tight macroeconomic policies but to stay above target until mid-2026. Upside risks to inflation persist, particularly if wage growth exceeds the rates agreed in 2024. An escalating tariff war could constrain goods exports. Volcanic activity could cause new infrastructure damage and require additional public spending on relief and resettlement.

Reforming the regulatory framework would help raise productivity

Implementing trade facilitation measures and reducing trade costs would promote international trade. Simplifying administrative procedures for start-ups would increase business dynamism. Easing the stringent regulations for foreign direct investment would accelerate access to the global technological frontier and strengthen business investment. Reforming the insolvency framework would contribute to the restructuring of viable firms and the exit of unviable ones. Reducing exemptions in the value-added tax (VAT) system, notably by subjecting tourism services to the standard VAT rate, would improve tax collection. Carrying out spending reviews, building on earlier experiences, and expanding the mandate of the Fiscal Council, could make public spending more efficient.