Winning the Inflation Fight: The Two Levers We Already Hold

This is the first in a series on the problems Iceland now has to solve at home — the ones I argued, through the referendum debate, were ours to fix rather than Brussels’. I want to start with inflation, because it sits upstream of everything else: it is why interest rates are high, why indexation exists, and why housing keeps drifting out of reach. The good news is that the tools to fight it are not exotic. They are the two levers every economy has. The question is whether we use both of them, well, and in coordination.

Let me start with the most important fact about Iceland’s inflation, because it reframes the whole problem — and it is not the fact most people assume.

Our inflation is homemade

For much of the past two years the story we told ourselves was that inflation was being done to us — imported, driven by oil, by war in the Middle East, by global supply chains. That was true for a while. It is not true now, and the data is unambiguous about it.

Break down July’s 5.3% inflation into what is actually driving it, and the imported component is negative. Imported goods are currently subtracting about 0.4 percentage points from the inflation rate — falling global oil prices, a firm króna, and summer sales are all pulling prices down. The outside world, right now, is helping.

So where is the 5.3% coming from? From us. The heaviest single contributor is housing — the imputed-rent machinery. Public services contribute about 1.3 points. Other domestic services add another point. Domestic goods, tourism, airfares. Strip it all down and the conclusion is inescapable: Iceland’s inflation today is domestically generated. It is homemade.

That is not bad news. It is the best news in this whole analysis — because a problem you make yourself is a problem you can fix yourself. Nobody in Frankfurt or Riyadh is holding the pen on Iceland’s inflation. We are.

Economics 101: you fight inflation with two legs, not one

Here is the textbook, and it is worth stating plainly because Iceland spent a long time behaving as though only half of it were true.

Inflation is fought with two instruments, held by two different institutions.

The first is monetary policy — the Central Bank’s job. When inflation is too high, the Bank raises interest rates, which makes borrowing and spending more expensive, cools demand, and eases prices. It is a demand-side brake, and it works — but it is blunt, and it falls hardest on exactly the people least able to bear it: households with mortgages, small businesses that need to borrow, young families trying to buy a first home.

The second is fiscal policy — the government’s job. And it works two ways. Through the budget balance: a government running large deficits pumps demand into the economy and adds to inflation, while a government running surpluses removes demand and eases it. And through administered prices: the government directly sets a whole range of prices and levies — public fees, healthcare charges, university fees, vehicle taxes — and every one of those, when it goes up, goes straight into the inflation number.

The point of having two legs is that neither one has to be pushed to a destructive extreme. If both pull together, the job gets done at moderate cost. If only one pulls, it has to pull brutally hard — and someone pays for that.

Which is exactly the situation Iceland found itself in. The policy rate is at 8% — raised three meetings in a row — in an economy that is already contracting. The Central Bank is pushing the monetary brake almost as hard as it can, deepening a slowdown, because for a long time it was carrying more of the load than it should have had to.

What a deficit actually does — and what the record shows

Before going further, it is worth being precise about what it means for a government to “run a deficit,” because the word gets used as though its meaning were obvious, and it is not.

A deficit means the government spends more than it collects in taxes and borrows the difference. But the economically important part is what that does to the economy. Taxes withdraw spending power; government spending puts it back, and then some. So a deficit is, on net, an injection of demand — more money moving through the economy than the government is taking out.

Whether that is good or bad depends entirely on one thing: the state of the economy when it happens. In a slump — a collapsed economy with idle workers and empty factories — a deficit fills the hole. It puts people back to work, and because there is slack to absorb the demand, it does not push up prices. That is why the deficits of 2008 and 2020 were the right call: the economy was falling, and it needed exactly that support. Nobody should apologise for those.

But run the same deficit when the economy is already hot — when workers are fully employed and prices are rising — and the injected demand has nowhere productive to go. There is no slack to absorb it, so instead of creating output, it bids up prices. A deficit in an overheating economy is inflationary. It adds demand the economy cannot meet, at the very moment the central bank is trying to remove demand. The two arms of the state end up pulling against each other.

I want to be fair about the distinction that matters here, because “deficits are bad” is a slogan, not an argument. A government that borrows to build a port or a power line or a hospital — capacity that raises the country’s productive potential for decades — is doing something entirely different from one that borrows to fund current spending it cannot cover. The first expands future supply and is, over time, disinflationary. The second adds demand without adding supply. Both appear as “a deficit” in the accounts; they are opposite economic acts. And there is a second cost, one that runs straight into the rest of this series: a deficit borrowed at home, from the same pension funds and savers who finance everything else, means the government is competing with its own citizens for a limited pool of capital — bidding, in effect, against the young family trying to get a mortgage, and helping to keep the cost of capital high.

So the honest question is never whether Iceland ran deficits. It is whether it ran them at the wrong time — adding demand when the economy was hot and the central bank was straining to cool it. And on that question, the record is clear enough to put in a single picture.

The chart sets three things side by side for every year from 2000 to 2025, all drawn from official data — Statistics Iceland for inflation and the government accounts, the Central Bank of Iceland for the policy rate. The black line is inflation. The pink dashed line is the Central Bank’s policy rate — the monetary lever. The bars are the government’s fiscal balance: blue in the years it ran a surplus, orange in the years it ran a deficit. The two shaded bands mark Iceland’s two big inflation episodes: 2008–10 and 2022–24.

Look at what the monetary lever does. In both inflation episodes, the pink line climbs steeply — to an average of more than 15% in 2008, and back up toward 9% in 2023–24. Every time inflation rose, the Central Bank pulled its lever, hard. It did its job.

Now look at the bars. Through both inflation episodes, they are orange. The government ran a deficit through the entire 2008–10 spike and through the entire 2022–25 spike — adding demand, or at best not removing it, in exactly the years the Central Bank was straining to take demand out. And notice where the blue surplus bars fall: in the calm, low-inflation years — 2004 to 2007, and 2014 to 2018. Iceland saved its restraint for the quiet times and loosened when things heated up. That is procyclical fiscal policy — leaning the wrong way — and it is visible at a glance.

Across the whole 26 years, Iceland ran a deficit in fifteen of them, and inflation averaged 4.9% — nearly double the 2.5% target — for a quarter of a century. (Two years are marked as one-offs and should not be read as ordinary policy: the enormous 2008 deficit was the bank collapse, and the outsized 2016 surplus was a one-time revenue from the failed banks’ estates.) But the pattern that matters is the one you can see without any statistics: one lever moved with inflation every time, and the other, if anything, moved against it.

This is the case for the two prescriptions that follow — not that anyone acted in bad faith, but that Iceland has leaned too hard on the single most painful lever, the one that falls on mortgage-holders and businesses, while the other lever was used sparingly or the wrong way. Sharing the load more evenly is not just fairer. It is what would let the painful lever be used less.

The good news: we are now using both legs

Here is the part that deserves to be said clearly, because it is true and it is encouraging: Iceland is now, finally, fighting inflation with both legs.

On the fiscal side, the government has turned the corner. The deficit has fallen from 3.4% of GDP in 2024 — a figure inflated by the Grindavík emergency, which was no one’s choice — toward a projected 0.8% in 2026, with a surplus targeted by 2028. Government debt has actually fallen, to 56% of GDP. The IMF describes the 2025 fiscal stance as “appropriately contractionary” and the 2026 stance as delivering a modestly negative fiscal impulse. In plain terms: fiscal policy has stopped adding fuel and started, gently, to help put out the fire.

That is the policy mix working as it should — monetary and fiscal pulling in the same direction toward a soft landing. Credit where it is due. This coordination is a real achievement, and it is why the Central Bank expects inflation to moderate through 2027.

So the task now is not to invent new tools. It is to use the two we have more sharply, and to understand what they can and cannot reach. Three prescriptions follow.

Prescription one: hold the consolidation, all the way to surplus

The single most important thing fiscal policy can do for inflation is finish the job it has started. The path to a surplus by 2028 is right, and rebuilding buffers matters especially for a small, shock-prone economy that will certainly face another storm.

The hard part is not designing the consolidation. It is holding it when growth slows, when a downturn bites, when an election looms and the temptation to loosen becomes overwhelming. Consolidation paths are abandoned all the time, precisely at the moment they matter most. The discipline — and it is genuinely difficult — is to reach the surplus and not flinch. That is the demand-side leg, and it is already moving in the right direction. It just has to keep moving.

Prescription two: use the price lever we directly control

This is the fastest-acting lever the government holds, and it is sitting right there.

Recall that about 1.3 percentage points of the 5.3% inflation rate comes from public services — and these are prices the government sets directly. The per-kilometre vehicle charge introduced at the start of 2026. Healthcare-centre fees, scheduled to rise in September. University registration fees. Petrol tax, set to climb back up as a temporary cut expires. Each of these is a policy choice, and each one, the month it takes effect, is added by the government’s own hand to the inflation number the Central Bank is then forced to fight with rates that fall on everyone.

The prescription is straightforward, and I want to frame it as opportunity rather than blame: in the middle of an inflation fight, the timing of administered-price increases is itself a policy instrument. Where a fee increase can wait until inflation is back near target, it should wait. Where revenue genuinely must be raised, it should be raised, where possible, through means that do not feed directly into the headline index. This is not a theoretical lever — the government has already shown it works, when it cut the fuel VAT from 24% to 11% to ease energy-driven inflation. That was the right instinct. The prescription is simply to use it systematically rather than once: to treat the government’s own price schedule as part of the inflation strategy, not separately from it.

And here is why this lever matters more than its 1.3 points suggest. In Iceland, administered prices do not just raise the index once. They feed into the wage-agreement review thresholds — the ones that, breached, reopen wage negotiations and start a fresh round of increases. And they feed into the balances of every indexed loan in the country. A point of administered-price inflation is therefore not a point. It is a point that gets amplified through the indexation machinery, again and again. Which brings us to the honest limit of everything in this piece.

What the two levers cannot reach

Monetary and fiscal policy, used well and together, can win the cyclical inflation battle. They can bring the 5.3% down toward 2.5%, and the coordination now in place is why that is a realistic expectation for the next couple of years.

But they cannot keep it there. Because the reason inflation in Iceland does not simply fall and stay down — the reason it keeps coming back, decade after decade — is not primarily cyclical. It is structural. It is the indexation flywheel: the machinery that takes every inflationary impulse and embeds it into wages, rents, and loan principals, so that a temporary shock becomes a permanent ratchet. No interest rate reaches that machine. No budget surplus dismantles it. The two levers in this piece can lower the water; they cannot fix the pump that keeps refilling the well.

That is the honest boundary of the inflation fight, and it is why this is the first piece in a series and not the whole answer. Win the cyclical battle with the two levers we already hold — hold the consolidation, use the price lever deliberately, keep the two arms coordinated — and inflation comes down. And when it comes down and stays down long enough to be believed, something crucial becomes possible: the Central Bank can begin to lower the policy rate from 8%. That is the moment the cost of capital starts to fall, and the moment the door to affordable housing and cheaper borrowing begins, at last, to open.

But to make the fall durable rather than temporary — to stop the flywheel from simply winding the inflation back up — we have to take on the machine itself. That is indexation, and it is where this series goes next.

The inflation is homemade. That is the whole hope of it. What we made, we can unmake — if we use both hands.

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Sources and notes

• Inflation and the policy rate. Headline inflation was 5.3% in July 2026 (Statistics Iceland, CPI July 2026), above 5% for all seven months of the year to date, against the Central Bank of Iceland’s 2.5% target. The Central Bank raised its key seven-day term-deposit rate by 25bp to 8.0% on 19 August 2026 — the third consecutive increase (7.25 → 7.5 → 7.75 → 8.0). (Statistics Iceland; Central Bank of Iceland; Trading Economics.)
• The decomposition of the 5.3%. Contributions to the July inflation rate, from Íslandsbanki’s analysis of the Statistics Iceland CPI: housing (imputed rent) the heaviest single component; public services 1.3 percentage points; other services 1.0; tourism 0.7; domestic goods 0.6; and imported goods minus 0.4 — i.e. imported goods were reducing headline inflation, reflecting lower global oil prices, a firm króna, and summer sales. (Íslandsbanki, “Inflation up slightly in July,” July 2026; Statistics Iceland.)
• Administered prices. The per-kilometre vehicle charge was added under public services at the start of 2026; primary healthcare-centre visit fees were scheduled to rise in September 2026 per a regulation announced by the Government Offices in early July; the temporary fuel-VAT reduction (from 24% to 11%) was set to expire, raising petrol prices. (Íslandsbanki; Landsbankinn Economic Research, August 2026; IMF Article IV 2026.)
• The fiscal position. The general government deficit was 3.4% of GDP in 2024 (inflated by the Grindavík eruptions), narrowing to a projected ~0.8% of GDP in 2026, with a surplus targeted by 2028; government debt fell to about 56% of GDP in 2025 from 60%. The IMF’s 2026 Article IV assessment describes the 2025 fiscal stance as “appropriately contractionary” and the 2026 stance as delivering a modestly negative fiscal impulse, and frames the objective as the appropriate policy mix to return inflation to target while achieving a soft landing; it notes that as inflation declines toward target, the policy rate should be reduced. (IMF Article IV 2025 and 2026; Statistics Iceland; Ministry of Finance; Trading Economics.)
• The amplification channel. Administered-price and other CPI increases feed into the inflation-assumption review thresholds of the 2024–2028 wage agreements and into the balances of CPI-indexed loans, so a given rise in the index can be propagated and repeated through the indexation machinery. This structural channel — and the case for dismantling it — is the subject of the next piece in this series.
• Caveat. Component contributions are Íslandsbanki’s estimates, consistent with the published Statistics Iceland CPI; figures move month to month and should be checked against the latest Statistics Iceland and Central Bank data at the time of reading.