A 2½% increase in public consumption is expected for both years. Gross fixed capital formation, however, is expected to grow by 10¾%, mainly as a result of investments connected with the aluminium industry. Forecast investment in residential housing is 3%. Exports will increase by 2% this year and 4% next year, according to the forecast, due to the increased fishing quotas that I mentioned earlier. Growth of imports is expected to be 4½% this year and 7% in 2004. Despite higher forecast output growth this year, unemployment is expected to be a quarter of a percentage point higher than was forecast in May, at 3¼%. Estimated slack in the labour market this year has been revised upwards. However, unemployment is expected to head down to a figure of 2½% next year. Although higher output growth is expected this year and next year, the output gap is forecast to become slightly negative. A revised estimate now shows a slightly negative output gap last year, which will widen even further in 2003 since output growth is below estimated growth of potential output. The output gap is expected to turn marginally positive next year, when output growth will exceed potential. However, it is important to bear in mind that the evaluation of the output gap is highly uncertain, due to the non-observable nature of potential output. These data do show, however, that good balance is expected in both 2003 and 2004. The Central Bank forecasts inflation up to two years ahead.
Over the past 12 months, Core Index I has risen by 2.7% and Core Index II by 2.4%. Underlying inflation is therefore somewhat closer than the CPI to the Central Bank’s target. It is interesting to examine the development of individual components of the CPI. The housing component, for example, has risen by 13.6% over the past 12 months and the upward trend shows no sign of coming to an end. Public service prices have also had a considerable impact on the CPI over the past 12 months, but the rate of increase has slowed down. Measures taken to forestall an inflation-  BIS Review 45/2003  1  triggered national wage review in 2002 included a freeze on public service prices, which was relaxed when the risk connected with exceeding negotiated inflation ceilings had abated. There has also been a slowdown in the twelve-month rise in private services, which are highly sensitive to domestic wage increases. On the whole, goods are more sensitive than many other index components to changes in the exchange rate. Last year’s strengthening of the króna is clearly reflected in goods prices, with a significant drop in import prices. In 2003 prices of both imported and domestic goods have fluctuated somewhat. For decades, a far too high rate of inflation was one of Iceland’s main economic problems. This had an adverse effect on businesses, making effective planning difficult. It also had an adverse effect on households, partly because a large proportion of household debt is indexed to inflation.