OECD Economic Outlook, Volume 2026 Issue 1

Iceland

GDP growth is set to increase from 1.3% in 2025 to 1.6% in 2026 and 2.2% in 2027, driven by private consumption and then a recovery in exports. The conflict in the Middle East is expected to affect Iceland mainly through higher import prices. Business investment is projected to rebound from a sharp fall in late 2025, while exports recover in 2027. Unemployment is set to rise to nearly 7% before easing somewhat in 2027. Inflation is expected to remain well above target in the near term and return close to target by end‑2027. Key risks include a wage‑price spiral, weak export demand and renewed volcanic activity.

The central bank raised the policy rate in two steps from 7.25% to 7.75% in spring 2026 and is expected to ease it gradually once the peak in energy prices is past. Fiscal policy is restrictive and set to remain so in 2026–27, with the underlying primary balance improving by about 1.4% of GDP in 2026 and 2027, respectively. This will support disinflation and rebuild fiscal space. Strengthening the regulatory framework for the power sector and easing the stringent regulations for foreign direct investment would help mitigate emerging energy supply constraints and improve growth prospects.

The economy is gradually recovering

Activity is gradually recovering, but slack remains amid persistently tight monetary conditions and high global uncertainty. Private consumption is holding up, supported by a steady increase in real wages. By contrast, services exports, notably tourism, are weakening. Following strong growth in the first half of 2025, business investment has declined as demand for AI‑related infrastructure and equipment has slowed. Housing investment remains subdued, reflecting slower population growth and restrictive financial conditions. The unemployment rate continues to edge up towards 6%. Headline consumer price inflation has increased to just over 5%, well above the 2.5% target. Price pressures are driven by higher oil and food prices, increased public levies and rising shipping costs. The contribution from housing inflation continues to ease.

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

Statlink

Iceland: Demand, output and prices

Statlink

Iceland is not very exposed to rising energy prices, as the country relies predominantly on domestic hydro and geothermal sources and the electricity grid is not interconnected with other countries. To mitigate higher transport costs, however, the government reduced VAT on fuel - measures set to expire in September - and stepped-up investment in charging infrastructure. Financial stress indicators suggest that the financial sector remains resilient, and loan arrears remain low.

Monetary and fiscal policies remain tight

The central bank raised its policy rate twice, by a total of 0.5 percentage points to 7.75% in spring 2026, as inflation expectations have risen, partly in the wake of the conflict in the Middle East. The bank is expected to reduce rates in late 2026 and early 2027 as inflation recedes. Fiscal policy is set to tighten, with the underlying primary balance projected to improve by about 1.4% of GDP per year in 2026 and 2027, driven mainly by stronger tax collection and lower spending on volcanic eruption relief. This fiscal consolidation is appropriate, as it will support disinflation and increase fiscal space.

Growth will be more robust

The economy is projected to grow by 1.6% in 2026 and 2.2% in 2027, driven by robust private consumption following substantial wage increases at the beginning of 2026. Exports are expected to grow slowly in 2026, with tourism expected to soften further amid weaker demand in origin countries and higher air travel costs, but marine product exports will strengthen. Exports are projected to recover in 2027, supported by stronger aluminium exports. As import growth is projected to remain subdued, net exports will contribute positively to growth, and the current account balance will improve. Business investment is projected to recover from its downturn in the second half of 2025, but to remain weak overall, reflecting low confidence. Risks remain elevated. A renewed surge in inflation and a reopening of wage agreements could trigger a wage‑price spiral. Prolonged weakness in destination markets could further weigh on exports, particularly tourism. Renewed volcanic activity could damage infrastructure and need additional public spending on relief and resettlement.

Regulatory reform could help boost electricity generation and transmission

Growing demand for electricity, partly driven by decarbonisation efforts and data centres, is straining Iceland's power system. Power shortages are becoming more frequent and prices are rising. The market is dominated by a few large producers and consumers linked by confidential agreements. Accelerating and simplifying administrative procedures for agreed power projects could help lift generation. Gradually expanding the wholesale market would increase efficiency of the electricity system. Dynamic pricing would help reduce pressure on generation and transmission during peak times. Easing the stringent regulations for foreign direct investment could also help lift investment in power generation.