Economic activity slowed through the first quarter of 2007, reflecting tight macroeconomic policies and the maturing of major aluminium-related investment projects. However, it revived subsequently as expansionary policy measures in the run-up to the general election in May rekindled demand and inflation pressures at a time when tensions and imbalances in the economy remained substantial. The further tightening of the monetary stance in the autumn should cool down the economy gradually in the period ahead. But the economy remains vulnerable to changes in foreign investor sentiment, especially in the context of fragile global financial-market conditions. Consequently, the key challenge for policy in the near term is to restore macroeconomic stability by ensuring that steady progress is made in unwinding both internal and external imbalances. In addition, with a view to sustaining Iceland’s favourable growth performance, steps need to be taken to strengthen the ability of both monetary and fiscal policy to moderate macroeconomic volatility and prevent the re-emergence of such imbalances. In a longer-term perspective, a key challenge for policymakers is health-care reform. Although the overall fiscal position is better than in many other OECD countries, health care (which is largely government-funded) is a major source of public spending pressures. Health outcomes are very good, but there appears to be room for enhancing cost-effectiveness.