Economist says rate hikes will not solve Iceland’s inflation

Raising interest rates is not always the right response to inflation in Iceland, according to Jaya Sood, an economist at the UK-based New Economics Foundation, in comments reported by mbl.is.

Sood was the keynote speaker at an open seminar organised by VR on Wednesday, where she discussed the advantages and disadvantages of interest rates as a tool for tackling high inflation.

She said inflation can have many causes. Interest rates are effective against some of them, but not all, making it important to identify the underlying causes before choosing a response.

Effective against demand-driven inflation

One cause is demand-driven inflation, which occurs when consumers have substantial disposable income, relatively high wages or easy access to credit. This can lead to excessive spending and an overheated economy, Sood said.

When supply and domestic production cannot meet demand, countries may turn to imports, which can put pressure on the exchange rate.

Interest rate increases can reduce this type of inflation by making borrowing more expensive, including the cost of mortgages. This can lead to lower investment and employment, cooling the economy, she said.

Iceland’s inflation is not mainly demand-driven

Sood said inflation in Iceland is more likely to be driven by imports than by domestic demand. Because the country relies heavily on imported goods, its economy is particularly vulnerable to rising prices abroad.

When the cost of imports increases, overall prices rise regardless of demand, she said. Events such as climate change or wars can raise the price of goods from abroad, and reducing demand in Iceland will not lower the price of those imported products.

She also pointed to Iceland’s current wage agreements, saying labour unions had agreed to a relatively modest wage package in 2024 that remained below inflation. This makes it unlikely that most of the inflation in Iceland has been driven by domestic demand, she said.

Inflation target may be difficult to reach

Asked whether a 2.5% interest rate benchmark is realistic for the Icelandic economy, Sood said it was difficult to assess.

She said there was an ongoing debate about whether countries should sometimes accept relatively higher inflation, provided wages rise in line with prices. There could therefore be an argument for the Central Bank accepting some supply-driven inflation that it has limited ability to influence.