The business cycle

Sedlabanki & ISK

By August 20, 2018 December 11th, 2018 No Comments

Real GDP growth is heading towards 4% this year and just under 3% next year in our view, supported by a still sizeable positive net export position, rising lending growth to the private sector and a tight labour market.

The current expansion phase is particularly long in historical context, as since 1967 the average length of the business cycle has been under 7 years long, while at the moment we are heading for 10 years of steady growth. A longer business cycle is due to the time it took to adjust the balance sheets after the banking crisis and it is helped by a low real policy rate in historical context. The peak of the business cycle was probably reached around the summer of 2017 – a bit earlier than the rest of Europe. This dynamic could imply that the timing of the next recession is one-three years away in our view.

Headline inflation has been modestly rising this year, but has stayed under 3%yoy since 2014, reflecting a growing contribution of food inflation and a fairly steady impact of fuel and housing inflation.

The overall inflation rate has been undershooting our model’s projections by about 0.6p.p. on average this year. This in our view means that inflation is proving slower than what historically would have happened given the level of activity and the strength of the labour market. Partly this is probably due to two critical factors: growing internal competition and growing external competition in the retail market due to the entrance of Costco in 2017.

Going forward, our model suggests an acceleration of inflation to around 4% from late this year/early 2019, which is likely to prompt a 50bp of tightening from the central bank in the coming 18 months.