Economist: Raising interest rates not the answer to Iceland's inflation

Jaya Sood, an economist at the New Economics Foundation in the UK, contends that high interest rates are not always the right tool to combat inflation. Speaking at a VR forum in Iceland, she highlighted that inflation can stem from various factors, and interest rates are only effective against certain causes.

Sood explained that demand-driven inflation occurs when consumers have excess money, leading to an overheated economy. In such cases, interest rate hikes make borrowing more expensive, thus cooling down the economy. However, she argued that Iceland's current inflation is primarily driven by imports, not domestic demand.

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When things like climate change or war happen outside our borders, prices for goods from abroad rise. Then, inflation is effectively imported, and cooling the economy and reducing demand will not do anything to lower the prices of these imported goods.

"When things like climate change or war happen outside our borders, prices for goods from abroad rise. Then, inflation is effectively imported, and cooling the economy and reducing demand will not do anything to lower the prices of these imported goods," Sood stated. She pointed to Iceland's reliance on imported goods, making its economy vulnerable to global price increases.

Further supporting her point, Sood referenced Iceland's current labor agreements, noting that unions accepted relatively modest pay increases for 2024, which have lagged behind inflation. This suggests that domestic demand is unlikely to be the main driver of the current price hikes.

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It is difficult to assess whether the 2.5% interest rate target is realistic for the Icelandic economy.