Inflation Dynamics and Key Drivers of Inflation: Iceland

Selected Issues Papers, August 7, 2026

Source details

Investigates why inflation in Iceland has remained persistently above target despite repeated tightening cycles, pointing to structural features that amplify and prolong price shocks.
Uses a two-stage empirical framework (Pedroni, 2013) to identify main drivers of Iceland’s inflation dynamics and explain why inflation responds more strongly to shocks than in peer economies.

Stage 1: Heterogeneous Panel SVAR for 45 countries to decompose sources of CPI fluctuations.
Stage 2: Cross-country regression linking the magnitude and persistence of pass-through to structural characteristics across countries.

Import price shocks dominate Iceland’s CPI fluctuations.
Import price shocks account for about three-quarters of forecast error variance at the eight-quarter horizon.
The import-price contribution in Iceland is nearly three times the panel median.
Wage shocks and domestic demand shocks play a smaller role in explaining Iceland’s CPI fluctuations.
Stronger and more persistent pass-through in Iceland is linked to structural characteristics, notably:
- Elevated inflation volatility.
- High union density.
The results suggest that less firmly anchored inflation expectations and wage-setting institutions help transmit external price shocks into domestic inflation.

Sustained disinflation would help reduce pass-through from external price shocks to domestic inflation.
Wage-setting practices more closely aligned with productivity developments would help reduce pass-through and strengthen the effectiveness of monetary policy.