Inflation - frequently asked questions (FAQ)
Why are prices rising so fast?
- Around half of the increase in the cost of living in Estonia has come from the rapid rise in energy prices, which has primarily been caused by the war started by Russia and by the lack of capacity for producing cheaper energy in the Baltic states.
- Higher energy costs will gradually be passed through into the prices of other goods and services.
- Inflation is being pushed up by strong demand, which supply has not been able to keep up with.
Various factors are causing inflation to be very high in Estonia. Around half of the increase in the cost of living in Estonia has come from the rapid rise in energy prices and about a quarter of inflation has been caused by higher food prices, while other factors have contributed less.
Energy prices have risen steeply because of the war in Ukraine and the sanctions on Russia, which have led Russia to stop or sharply reduce supplies of fuels and energy. This confrontation and the need for alternative sources of energy have driven up the prices of fuels on global markets. The price of gas has risen particularly high. Increasing demands to replace gas with coal or other more polluting fuels has raised the price of emissions quotas in Europe. The price of electricity has risen sharply in the Baltic region because there is a lack of capacity here for producing cheaper electricity. Neither are there enough connections to import cheaper electricity from Scandinavia, where electricity may be cheaper in places, but where there are also shortages and problems with transmission capacity and with low water levels at hydroelectricity stations as a result of the dry weather.
The consumer basket has also been made more expensive by higher prices for other goods and services, which means that inflation has become broadly based. This is partly because the higher cost of energy has been passed into the production costs of businesses. On top of this, the sanctions on Russia and the supply problems that were initially caused by the pandemic have raised the prices of inputs for a range of products, pushing up the price of end products for the consumer. When setting their prices, Estonian businesses have also had to consider faster increases in wage costs than businesses in many other European Union countries have.
Alongside these cost pressures in production, strong demand has created space for prices to rise. Supply problems and other issues have meant that the volumes of products available in many groups of goods have been unable to keep up with demand, with the consequence that prices have risen.
Why is inflation much higher in Estonia than in other countries in the euro area?
- The share of the monthly spending of Estonian consumers that goes on products like energy and food, for which prices have risen the most, is larger than that elsewhere in Europe.
- The Estonian economy recovered from the pandemic faster than other European economies did, causing demand to revive for goods and services.
The sharp rise in the price of electricity, and in the prices of other fuels, has been of particular importance, as it has accounted for around half of inflation in Estonia. The goods for which prices have particularly risen, like energy and food, account for a larger share of the monthly spending of consumers in Estonia than elsewhere in Europe.
To this can be added general upwards price pressures, which have been boosted by the generally good state of the Estonian economy and increased demand. The Estonian economy was one of the fastest in Europe to recover from the pandemic, and at the end of 2021 Estonian businesses already considered that the economy was in a similar state to where it was in the boom year of 2007. This was indicated by low unemployment, worsening labour shortages, and the most intensive utilisation ever of production capacity. Demand for goods and services in the Estonian economy has been boosted by labour shortages, rapid growth in wages, savings built up during the pandemic, a state budget deficit, and the money released from the second pension pillar.
Price setting in Estonia is also more flexible than it is in most European countries, and prices react strongly to both positive and negative changes in the economy. When the economy deteriorated at the start of the pandemic in 2020, Estonia stood out for the drop in its consumer prices at a time when prices in the euro area as a whole continued to rise slowly.
Why is inflation particularly high in the Baltic states, and what are the differences between the three countries?
There are several reasons why inflation is higher in the Baltic states than the average in the euro area. The share of energy goods in the purchasing basket of consumers in the Baltic states is larger, which has affected the rise in the price of the consumer basket. Natural gas and electricity were a little cheaper in the region before Russia's invasion of Ukraine, but prices have now caught up to those in other countries. Countries have tried to ease the impact on consumers from high energy prices, but have differed in the range of measures and how they have been applied.
Inflation has been higher in Estonia than in Latvia and Lithuania for some time. The majority of the difference has been caused by steeper rises in energy prices, while the price of the rest of the consumer basket has increased at similar rates. Under normal circumstances, overall inflation would be expected to be lower in Estonia than in the other two Baltic states, as the level of consumer prices had already risen notably higher in Estonia in previous years, and so had come closer to the level in the rest of the euro area. The consumer basket in Estonia is around 10% more expensive than that in Latvia, and some 15% more expensive than that in Lithuania. That many goods and services are still rising in price at more or less the same rate indicates a stronger demand environment and the pressure it is putting on prices. The sentiment surveys of the European Commission also point to stronger consumer demand in Estonia, and this can be explained by both rapidly increasing incomes, and the spending of savings built up during the pandemic together with the money withdrawn from the second pension pillar.
Why have real estate prices risen so fast recently?
- Real estate prices have largely been driven by strong demand, cheap loans with low interest rates, and the slow rate at which new housing has come to the market.
- New properties have been hindered in coming to the market above all by the shortages of construction materials caused by the pandemic and the war, supply difficulties, very high prices, and labour shortages.
Housing prices have risen fast because demand for real estate has been very strong. The strong demand has been driven by low interest rates, low unemployment, rapid wage rises, savings built up during the pandemic, and the money withdrawn from the second pension pillar fund. It is probable that real estate is also being bought as a defence against high inflation. The availability of housing loans has also increased in the past couple of years, as additional banks issuing such loans have entered the market.
Supply has increased slowly in the housing market. Development and construction have been hindered by the shortages of construction materials caused by the pandemic and the war, supply difficulties, very high prices, and labour shortages. This makes it harder to plan new development, and means the cost of building is much higher than previously.
Who can control inflation and how?
- The European Central Bank can use monetary policy to steer inflation in the euro area through interest rates and through the amount of money circulating in the economy.
- Governments can rein in inflation through the state budgets, by spending less and building up reserves while the economy is growing fast and doing the opposite when it is performing poorly.
How does the monetary policy of the European Central Bank affect inflation?
It is the task of the European Central Bank to keep inflation in the euro area as a whole at close to 2% over the medium term of 2-3 years. The central bank can affect inflation through its monetary policy decisions.
There are two main ways that monetary policy can affect inflation. The first is by changing interest rates, which set the price of money. The second is by steering the amount of money circulating in the economy, which can if necessary be altered through asset purchases and through lending to commercial banks or depositing their reserves.
If the economy needs cooling, the central bank can increase the price of money by raising interest rates. Another option is to restrict the growth in the amount of money in the economy by making fewer asset purchases, selling financial assets that have already been bought, or limiting lending to the commercial banks. Such measures slow the rate of growth in the economy and so also slow inflation. The opposite can be done if it is necessary to boost the economy, by lowering the price of money and increasing the amount of it in the economy.
It should be noted though with monetary policy that it takes a long time for its full impact to pass into prices, as this is felt only after two or three years. Nor is it possible for monetary policy to affect the prices of individual products. The central bank cannot for example affect the price of oil and other fuels on the global market, as changes in interest rates have no direct impact on the amounts of energy produced and consumed. The most reasonable response of monetary policy to the current very high inflation in the countries of the euro area, which has largely been caused by a fuel price shock, would be to steer expectations that inflation in a couple of years time will still be around 2%. Tightening monetary policy too fast could put too much pressure on the economy at a difficult time.
How does fiscal policy affect inflation?
The monetary policy target of the European Central Bank is to keep average consumer price inflation in the euro area close to 2%. If the state of the economy in a country in the euro area, and consequently its inflation rate, deviates from the average, that difference can be smoothed with national economic policies, especially fiscal or budget policy. Governments can use a well-targeted fiscal policy to smooth sharp changes in the economy, by supporting the economy with additional spending during hard times, and by spending less or building up reserves when the economy is growing fast. The government affects economic activity in the country through how much it takes money in with one hand through taxation and puts it back into the economy with the other hand through state budget spending on civil servants' salaries or road building or other expenses.
If the government spends more money than it receives from taxes and other forms of income, there is a budget deficit and the additional money that is poured into the economy boosts demand and so raises prices. How the money injected into the economy affects inflation depends on the state of the economy at that point in time. Using a budget deficit to revive an economy during a downturn may not cause prices to rise, as some production capacity may otherwise have stood idle without that support. If the economy is doing well though and the private sector is running at full capacity, spending additional money through the state budget can have an inflationary impact. This is because production volumes may prove unable to increase at the same rate that demand does if the existing production capacity is already fully employed. The result is that there are not enough goods on sale to satisfy the demand to buy them, and so prices rise.
What impact has the money printing of the European Central Bank had on inflation?
- The creation of money had a limited impact, as a large part of the money injected into the economy did not reach people and businesses, but was deposited by the commercial banks back with the central bank.
- The impact on Estonia has been felt through very cheap loans and low interest rates, and indirectly through the support that the European economy received from money printing.
The aim of the asset purchases of the European Central Bank, which has been called money printing, was to revive the economy in the euro area so that it would not fall into a deflationary spiral that would threaten economic growth, jobs, and the ability to repay debts. The goal was to raise inflation, which was tending to remain well below the target of 2% for the euro area in the past decade. The direct impact of money creation on inflation was limited though because a large part of the money that was added to the economy did not actually reach people and businesses. The activities of the central bank managed to increase the growth in lending, but the commercial banks did not find enough opportunities to lend all this money onwards to their clients. The commercial banks consequently deposited a large part of it back with the central bank.
The impact of the money creation on Estonia has been felt through very cheap loans and low interest rates. Although Eesti Pank was not able to buy many local bonds, the Estonian economy still benefited from the cheap conditions for lending in the euro area. The bond purchases had an indirect impact in Estonia through the prices of imports and probably through stronger demand in the markets for Estonian exports.
 The monetary policy target of the European Central Bank is to keep inflation in the euro area as a whole close to 2% over the medium term.
What can Eesti Pank do to steer inflation in Estonia?
- Eesti Pank participates in making monetary policy decisions at the European Central Bank.
- Eesti Pank advises the government by assessing and describing the impact of its policy choices.
Eesti Pank works with the other central banks of the euro area in taking monetary policy decisions, though it must consider the state of the euro area as a whole. Eesti Pank also advises the government of the Republic regularly on important points of economic policy. The central bank helps primarily in assessing and describing the impact on the economy of different policy choices.
Eesti Pank assessed how the monetary policy of the euro area affected the Estonian economy in a thorough review in 2020. The review concluded that overall economic growth in Estonia was around 1 percentage point faster in total in 2017 and 2018 and inflation 0.2-0.3 percentage point higher because of euro area monetary policy than would otherwise have been the case. This review can be read in greater detail on the Eesti Pank website.
How can the impact of higher energy prices on Estonian consumers be eased?
- Eesti Pank considers that help in coping with higher energy prices should be targeted at those who need it the most.
The main cause of high inflation in Estonia at the present time is the sharp rise in the price of energy. It should be noted though that the Estonian economy has continued to perform well despite everything, and so care must be taken when any possible support is planned that excessive amounts of additional money are not poured into the economy, as this could cause high inflation to rise even higher. It would be wiser, and more efficient when spending taxpayers money, to target the assistance at those who are facing the greatest difficulties because of higher inflation. People on lower incomes direct a notably larger part of their monthly spending to food and energy, which are the goods that have seen prices rise the most. Energy prices have risen in the region primarily because of a lack of production capacity, and so the long-term solution would be to increase that capacity.
Data from the International Monetary Fund (IMF) from around the world show that government interference in prices by treating all consumer groups equally does not in the long term reduce the increase in the cost of living. The IMF also recommends avoiding distortions in how the market sets prices, as that does not encourage people to consume expensive goods more sparingly.
Last updated 30.08.2022