Inflation Dynamics and Key Drivers of Inflation: Iceland

Inflation in Iceland has remained persistently above target despite repeated tightening cycles, pointing to structural features that amplify and prolong price shocks. This paper uses a two-stage empirical framework (Pedroni, 2013) to identify the main drivers of Iceland’s inflation dynamics and explain why inflation responds more strongly to shocks than in peer economies. A heterogeneous Panel SVAR for 45 countries shows that import price shocks dominate Iceland’s CPI fluctuations, accounting for about three-quarters of forecast error variance at the eight-quarter horizon—nearly three times the panel median—while wage and domestic demand shocks play a smaller role. A second-stage cross-country regression links Iceland’s stronger and more persistent pass-through to its structural characteristics, notably elevated inflation volatility and 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 and wage-setting practices more closely aligned with productivity developments would help reduce pass-through and strengthen the effectiveness of monetary policy.