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Iceland: Sixth Post-Program Monitoring Discussions—Staff Report

Summary: KEY ISSUES Iceland’s otherwise strong and stable economic position looks likely to be disrupted by significant wage hikes. Collective wage bargaining looks headed for economy-wide cumulative 3½-year nominal wage growth of 20–25 percent, along with fiscal measures costing ½ percent of GDP annually to help break an impasse between social partners. With a closed output gap and modest productivity gains, this would propel inflation well above the Central Bank of Iceland’s (CBI) 2.5 percent target, generate budget pressures, erode competitiveness, and slow capital account liberalization. A decisive policy response will be needed. Excess demand pressures will likely boost economic growth this year. Monetary policy tightening will be needed to bring inflation back down to target. Fiscal policy should be adjusted to reduce demand pressures, while staying on track to achieve debt reduction objectives. Fiscal adjustment plans will need to become more specific. The tighter policies are expected to pull inflation gradually toward the target and slow real GDP growth in 2016 and beyond. Iceland looks ready to finalize its updated capital account liberalization strategy. Considerable effort has been made to better understand the challenges, risks, and range of options for addressing Iceland’s still-significant balance of payments (BOP) overhang, estimated at 65–70 percent of GDP. The authorities look ready to proceed with an updated comprehensive, conditions-based liberalization strategy, while maintaining stability and giving emphasis to a cooperative approach with incentives. However, the pace of implementation, particularly for the real sector, may be slowed by macroeconomic volatility and erosion in competitiveness from large wage hikes. Efforts to strengthen core policy frameworks are broadly on track. Approval of an ambitious budget framework law (Organic Budget Law, or “OBL”) is expected soon. Important draft laws to bring financial sector safety nets in line with European Economic Area (EEA) standards and to strengthen the macroprudential policy framework are expected to be passed later this year. Critical efforts to strengthen financial supervision are continuing. Work to refine the monetary policy framework and the role of macroprudential policies is underway. A review of central bank legislation will continue later this year and should aim for an outcome consistent with maintaining independence and accountability. Final agreement on run-off of the loss-making Housing Financing Fund (HFF) and a successor strategy remains elusive.