## Section 1 — Inflation Dynamics and Key Drivers of Inflation

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---

### A. Introduction
- Inflation in Iceland has averaged 4.9 percent since the inflation target was adopted in 2001.
- Over the post-crisis period (2011–25), inflation averaged 4.0 percent and exceeded the target in roughly two-thirds of months.
- The central bank’s policy rate has averaged 5 percent since 2011 with a maximum of 9.25 percent and a minimum of 0.75 percent.
- Iceland is a highly open, commodity-exporting economy with substantial services exports, exposing it to large external price shocks.
- Structural features highlighted as potentially amplifying and prolonging shocks: elevated union density and near the low end of policy-rate pass-through.

### B. Methodology
- Two-stage empirical framework following Pedroni (2013):
  - Stage 1: Heterogeneous Panel SVAR for 45 countries using four variables — real GDP growth, nominal wage growth, CPI inflation, and import price growth — with Blanchard-Quah (1989) long-run restrictions.
  - Stage 2: Cross-country regression linking cumulative CPI impulse responses (at the eight-quarter horizon) to structural characteristics: union density, trade openness, inflation volatility, strength of monetary transmission via the lending channel, and inflation-targeting regime.
- VAR ordering: [GDP, wages, import prices, CPI].
- Lag length in each country VAR selected by the Akaike Information Criterion (AIC).
- Long-run restrictions summary (Table 1):
  - GDP shock → GDP ✓, Wages 0, Import prices 0, CPI 0
  - Wage shock → GDP ✓, Wages ✓, Import prices 0, CPI 0
  - Import price shock → GDP ✓, Wages ✓, Import prices ✓, CPI 0
  - CPI shock → GDP ✓, Wages ✓, Import prices ✓, CPI ✓

### C. Data
- Panel comprises 45 advanced and emerging market economies over the sample window 2011Q1-2025Q3.
- Core VAR variables expressed as annualized quarterly log-differences; seasonal adjustment applied using STL decomposition with a seasonal window of four quarters.
- Cross-sectional regressors:
  - Trade openness = exports + imports as a share of GDP.
  - Service-to-goods export ratio captures sectoral composition.
  - Union density from ILO and OECD ICTWSS databases.
  - Strength of monetary transmission captured by sum of pass-through coefficients from policy rate changes to bank lending rates.
  - Inflation volatility = annualized standard deviation of quarterly CPI inflation over the sample period.
- Iceland: extreme upper end on union density and close to the lower end on strength of the bank lending channel.

### D. Results
- Forecast error variance decomposition (h = 8 quarters) — Table 2:
  - Iceland: Import Price 75%, Own-CPI 11%, Wages 11%, Supply (GDP) 3%
  - Panel Median: Import Price 26%, Own-CPI 13%, Wages 33%, Supply (GDP) 20%
- Key findings:
  - Import price shocks dominate Iceland’s CPI fluctuations, accounting for 75 percent of forecast error variance at the eight-quarter horizon — nearly three times the panel median of 26 percent.
  - Wage shocks account for 11 percent of Iceland's CPI variance versus a panel median of 33 percent.
  - GDP (supply) shocks account for 3 percent versus a panel median of 20 percent.
  - A one-standard-deviation import price shock raises Iceland's CPI by close to 1 percentage point at its peak in the third quarter; the response is larger and more persistent than the panel median.
- Cross-country regression (dependent variable: Cumulative IRF h=0-8 quarters) — selected coefficients and statistics (Table 3):
  - Import price → CPI column:
    - Intercept: -2.4***
    - Lending channel (θ): +0.0**
    - Union density: -0.2
    - Trade openness: +0.0
    - UD × Openness: +1.9***
    - Inflation volatility: 0.68
    - R²: 0.64
  - Wage → CPI column:
    - Intercept: -0.1
    - UD × Openness: +1.7***
    - Inflation volatility: 0.56
    - R²: 0.50
  - GDP → CPI and CPI persistence columns (select entries):
    - GDP → CPI intercept: +2.8
    - CPI persistence intercept: +1.0
    - CPI persistence UD × Openness: +0.6**
    - GDP → CPI Inflation volatility: 0.18; R²: 0.06
    - Wage → CPI Inflation volatility: 0.27; R²: 0.16
  - Significance notation: *** p<0.01, ** p<0.05, * p<0.10. HC3 robust S
- Interpretation of regressions:
  - Inflation volatility is the most robust predictor of stronger and more persistent import price pass-through: countries with more volatile inflation histories transmit import price shocks more strongly into consumer prices.
  - Union density enters positively and significantly in explaining higher cumulative CPI responses to import price shocks, consistent with wage-setting institutions embedding external price increases into domestic costs through bargaining rounds.
  - Trade openness and strength of the lending-channel monetary transmission do not enter significantly in most specifications, suggesting the pass-through operates mainly via inflation expectations and wage-setting channels rather than goods-market competition or the interest-rate channel.
- Fit and Iceland’s position:
  - The second-stage regression fits Iceland's estimated impulse response closely; Iceland’s elevated pass-through is well explained by its higher inflation volatility and high union density.

### E. Conclusions and Policy-relevant Implications
- Main conclusions:
  - Import price shocks are the dominant driver of Iceland's CPI, accounting for 75 percent of forecast error variance at the eight-quarter horizon — nearly three times the cross-country sample median.
  - Iceland's excess sensitivity reflects structural characteristics, notably elevated inflation volatility and high union density.
  - Less firmly anchored inflation expectations (captured by higher inflation volatility) amplify and prolong pass-through of external price shocks.
  - High union density likely transmits import price increases into domestic wages and prices through successive bargaining rounds.
- Policy-relevant implications highlighted in the analysis:
  - Sustained disinflation could help firmly anchor inflation expectations and thereby reduce import price pass-through — described as a virtuous cycle in which disinflation begets disinflation.
  - Wage-setting practices more closely aligned with productivity developments would help reduce pass-through and strengthen the effectiveness of monetary policy.

### Section 2 — Policy Implication, Limitations, and Annex

### Policy implication: wage-setting and inflation persistence
- Structural measures that strengthen the link between wage settlements and productivity — rather than realized inflation — would help moderate second-round effects and reduce the degree to which external shocks become entrenched in domestic prices.

### Limitations and directions for further research
- Two limitations of the analysis merit acknowledgment:
  - First, Iceland's extensive system of CPI-indexed financial contracts and wage agreements is likely an additional channel that operates independently of union density and warrants further analysis.
  - Second, the results could be assessed for sensitivity to a broader set of VAR variables in Stage 1 and structural characteristics in Stage 2, as well as alternative methods such as local projections.
- Both limitations point to productive directions for further research.

### Annex I. Country List
- Advanced Economies: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Israel, Italy, Japan, Korea, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, United Kingdom, United States.
- Emerging Market Economies: Brazil, Bulgaria, Chile, China, Colombia, Croatia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, Slovak Republic, Slovenia, South Africa, Thailand, Turkey, Ukraine.

*Prepared by Amit Kara and Yurii Sholomytskyi; IMF Selected Issues Paper (SIP/2026/082), completed July 10, 2026.*

### Section 1

### Inflation Dynamics and Key Drivers of Inflation

### A. Introduction
- Inflation in Iceland has averaged 4.9 percent since the inflation target was adopted in 2001.
- Over the post-crisis period (2011–25), inflation averaged 4.0 percent and exceeded the target in roughly two-thirds of months.
- The central bank’s policy rate has averaged 5 percent since 2011 with a maximum of 9.25 percent and a minimum of 0.75 percent.
- Iceland is a highly open, commodity-exporting economy with substantial services exports, exposing it to large external price shocks.
- Structural features highlighted as potentially amplifying and prolonging shocks: elevated union density and near the low end of policy-rate pass-through.

### B. Methodology
- Two-stage empirical framework following Pedroni (2013):
  - Stage 1: Heterogeneous Panel SVAR for 45 countries using four variables — real GDP growth, nominal wage growth, CPI inflation, and import price growth — with Blanchard-Quah (1989) long-run restrictions.
  - Stage 2: Cross-country regression linking cumulative CPI impulse responses (at the eight-quarter horizon) to structural characteristics: union density, trade openness, inflation volatility, strength of monetary transmission via the lending channel, and inflation-targeting regime.
- VAR ordering: [GDP, wages, import prices, CPI].
- Lag length in each country VAR selected by the Akaike Information Criterion (AIC).
- Long-run restrictions summary (Table 1): ✓ denotes permitted permanent effect; 0 denotes restriction to zero in the long run.
  - GDP shock → GDP ✓, Wages 0, Import prices 0, CPI 0
  - Wage shock → GDP ✓, Wages ✓, Import prices 0, CPI 0
  - Import price shock → GDP ✓, Wages ✓, Import prices ✓, CPI 0
  - CPI shock → GDP ✓, Wages ✓, Import prices ✓, CPI ✓

### C. Data
- Panel comprises 45 advanced and emerging market economies over the sample window 2011Q1-2025Q3.
- Core VAR variables expressed as annualized quarterly log-differences; seasonal adjustment applied using STL decomposition with a seasonal window of four quarters.
- Cross-sectional regressors:
  - Trade openness = exports + imports as a share of GDP.
  - Service-to-goods export ratio captures sectoral composition.
  - Union density from ILO and OECD ICTWSS databases.
  - Strength of monetary transmission captured by sum of pass-through coefficients from policy rate changes to bank lending rates.
  - Inflation volatility = annualized standard deviation of quarterly CPI inflation over the sample period.
- Iceland: extreme upper end on union density and close to the lower end on strength of the bank lending channel.

### D. Results
- Forecast error variance decomposition (h = 8 quarters) — Table 2:
  - Iceland: Import Price 75%, Own-CPI 11%, Wages 11%, Supply (GDP) 3%
  - Panel Median: Import Price 26%, Own-CPI 13%, Wages 33%, Supply (GDP) 20%
- Key findings:
  - Import price shocks dominate Iceland’s CPI fluctuations, accounting for 75 percent of forecast error variance at the eight-quarter horizon — nearly three times the panel median of 26 percent.
  - Wage shocks account for 11 percent of Iceland's CPI variance versus a panel median of 33 percent.
  - GDP (supply) shocks account for 3 percent versus a panel median of 20 percent.
  - A one-standard-deviation import price shock raises Iceland's CPI by close to 1 percentage point at its peak in the third quarter; the response is larger and more persistent than the panel median.
- Cross-country regression (dependent variable: Cumulative IRF h=0-8 quarters) — selected coefficients and statistics (Table 3):
  - Import price → CPI column:
    - Intercept: -2.4***
    - Lending channel (θ): +0.0**
    - Union density: -0.2
    - Trade openness: +0.0
    - UD × Openness: +1.9***
    - Inflation volatility: 0.68
    - R²: 0.64
    - Adj R²: (not separately listed in the source block)
  - Wage → CPI column:
    - Intercept: -0.1
    - UD × Openness: +1.7***
    - Inflation volatility: 0.56
    - R²: 0.50
  - GDP → CPI and CPI persistence columns also reported in the table; select entries:
    - GDP → CPI intercept: +2.8
    - CPI persistence intercept: +1.0
    - CPI persistence UD × Openness: +0.6**
    - GDP → CPI Inflation volatility: 0.18; R²: 0.06
    - Wage → CPI Inflation volatility: 0.27; R²: 0.16
  - Significance notation: *** p<0.01, ** p<0.05, * p<0.10. HC3 robust S
- Interpretation of regressions:
  - Inflation volatility is the most robust predictor of stronger and more persistent import price pass-through: countries with more volatile inflation histories transmit import price shocks more strongly into consumer prices.
  - Union density enters positively and significantly in explaining higher cumulative CPI responses to import price shocks, consistent with wage-setting institutions embedding external price increases into domestic costs through bargaining rounds.
  - Trade openness and strength of the lending-channel monetary transmission do not enter significantly in most specifications, suggesting the pass-through operates mainly via inflation expectations and wage-setting channels rather than goods-market competition or the interest-rate channel.
- Fit and Iceland’s position:
  - The second-stage regression fits Iceland's estimated impulse response closely; Iceland’s elevated pass-through is well explained by its higher inflation volatility and high union density.

### E. Conclusions and Policy-relevant Implications
- Main conclusions:
  - Import price shocks are the dominant driver of Iceland's CPI, accounting for 75 percent of forecast error variance at the eight-quarter horizon — nearly three times the cross-country sample median.
  - Iceland's excess sensitivity reflects structural characteristics, notably elevated inflation volatility and high union density.
  - Less firmly anchored inflation expectations (captured by higher inflation volatility) amplify and prolong pass-through of external price shocks.
  - High union density likely transmits import price increases into domestic wages and prices through successive bargaining rounds.
- Policy-relevant implications highlighted in the analysis:
  - Sustained disinflation could help firmly anchor inflation expectations and thereby reduce import price pass-through — described as a virtuous cycle in which disinflation begets disinflation.
  - Wage-setting practices more closely aligned with productivity developments would help reduce pass-through and strengthen the effectiveness of monetary policy.

*Prepared by Amit Kara and Yurii Sholomytskyi; IMF Selected Issues Paper (SIP/2026/082), completed July 10, 2026.*

### Section 2

### sipea2026082 - Section 2

### Policy implication: wage-setting and inflation persistence
- Structural measures that strengthen the link between wage settlements and productivity — rather than realized inflation — would help moderate second-round effects and reduce the degree to which external shocks become entrenched in domestic prices.

### Limitations and directions for further research
- Two limitations of the analysis merit acknowledgment:
  - First, Iceland's extensive system of CPI-indexed financial contracts and wage agreements is likely an additional channel that operates independently of union density and warrants further analysis.
  - Second, the results could be assessed for sensitivity to a broader set of VAR variables in Stage 1 and structural characteristics in Stage 2, as well as alternative methods such as local projections.
- Both limitations point to productive directions for further research.

### Annex I. Country List
- The panel comprises the following 45 advanced and emerging market economies:
  - Advanced Economies: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Israel, Italy, Japan, Korea, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, United Kingdom, United States.
  - Emerging Market Economies: Brazil, Bulgaria, Chile, China, Colombia, Croatia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, Slovak Republic, Slovenia, South Africa, Thailand, Turkey, Ukraine.

### References (as listed)
- Blanchard, O. and D. Quah, 1989, “The Dynamic Effects of Aggregate Demand and Supply Disturbances,” American Economic Review, Vol. 79, No. 4, pp. 655–673.
- Einarsson, B.G. and T.G. Pétursson, 2026, “What Sets the Trend? The Evolution and Drivers of Icelandic Trend Inflation,” Central Bank of Iceland Working Paper No. 100.
- Pedroni, P., 2013, “Structural Panel VARs,” Econometrics, Vol. 1, No. 2, pp. 180–206.

*Source: sipea2026082 - Section 2*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2026/english/sipea2026082.pdf_