IMF Concludes 2024 Article IV Consultation with Iceland

The mission concluded with a positive outlook on Iceland's economy, noting strong macroeconomic management and significant progress in reducing domestic and external imbalances.

An International Monetary Fund (IMF) mission, led by Magnus Saxegaard and including Thomas Gade, Fazurin Jamaludin, and Amit Kara, conducted the 2024 Article IV consultation with Iceland from May 7 to 22, 2024. The mission concluded with a positive outlook on Iceland's economy, noting strong macroeconomic management and significant progress in reducing domestic and external imbalances.

Economic Overview and Outlook

Iceland's economy grew by a robust 4.1 percent in 2023 but began to cool toward the end of the year. The economy is now operating closer to capacity, with high interest rates and tight fiscal policy helping to slow consumption and investment while boosting household savings. The current account balance has turned positive due to strong tourism receipts, despite disruptions from volcanic activity around Grindavík.

For 2024, economic growth is expected to slow to 1.7 percent before rebounding to 2 percent in 2025. Inflation is projected to decline from 4.8 percent by the end of 2024 to 2.8 percent by the end of 2025. Medium-term growth prospects are favorable, driven by innovation-based sectors and migrant labor inflows supporting employment growth.

Risks and Policy Recommendations

Risks to the outlook are balanced. Downside risks include a sharper contraction in domestic demand or an increase in inflation due to higher wages or import prices. Upside risks include a faster-than-expected recovery in private consumption and stronger contributions from the pharmaceutical, biotechnology, and carbon capture sectors.

Macroeconomic Policies

Fiscal Policy: Building Buffers and Ensuring Sustainability

The IMF recommends additional fiscal measures to build buffers and maintain fiscal sustainability. This includes reducing items subject to reduced VAT rates, streamlining tax expenditures, and increasing taxation on capital gains from second homes. The reactivation of fiscal rules in 2026 should focus on reducing pro-cyclicality and ensuring fiscal sustainability.

Monetary Policy: Calibrating to Bring Inflation to Target

The Central Bank of Iceland (CBI) should maintain a tight monetary policy stance to bring inflation back to target. As inflation declines, the policy rate should be gradually lowered to avoid unnecessary economic cooling. The IMF also suggests that the CBI be prepared to use foreign exchange interventions during times of stress to maintain stability.

Financial Sector: Ensuring Robustness and Stability

Despite pressures from higher interest rates, Iceland's financial sector remains robust. Supervisory efforts should focus on monitoring asset quality and maintaining strong liquidity buffers. The IMF recommends clarifying the neutral level of the countercyclical capital buffer (CCyB) and continuing to implement Financial Sector Assessment Program (FSAP) recommendations.

Structural Policies

Supporting Innovation and the Green Transition

Iceland's structural policies should continue to foster innovation and diversify the economy. This includes clarifying R&D tax credit criteria, improving educational outcomes, and investing in infrastructure. Achieving Iceland’s ambitious climate agenda will require raising carbon taxes, incentivizing CO2 capture, and scaling up renewable energy investments.

Strengthening Fiscal Institutions

Enhancing fiscal institutions will support the credibility of fiscal rules. This includes increasing resources for the Fiscal Council and improving transparency by publishing quarterly data on fiscal aggregates. These measures will help ensure that fiscal policy remains sustainable and contributes to macroeconomic stability.

The IMF mission concluded by thanking the Icelandic authorities for their hospitality and constructive dialogue during the consultation.