The broader impact on the economy of Russia’s war will be felt in the second half of the year



The Estonian economy started the year in a very strong position, but growth in it will slow. Growth would have slowed substantially this year even without a new crisis. Production resources were already running at full capacity by the end of last year, and deepening supply-side restrictions had started to get in the way of continued fast growth. The outbreak of war in February and the various impacts from it overshadow the outlook for the Estonian economy further, through the disappearance of some export markets, the interruptions to supply channels, and the rise in the price of commodities. While sanctions on Russia have already led to rapid price rises, the broader impact on the economy will only start to become apparent in the second half of the year.

Inflation is expected to be lower next year, but the price level will still remain high. Inflation in Estonia has been the fastest in the euro area in recent months, mainly because of the major rise in energy prices. Higher energy costs will gradually be passed through into the prices of many other goods and services. As future transactions for gas, electricity and oil show no sign of prices falling soon, because of the geopolitical tensions, the price level of the consumer basket will remain high for a longer time than was earlier forecast.

Inflation is also high because of domestic factors. That inflation is twice the average in the euro area can be explained not only by rising energy prices but also by the rapid growth in Estonia in incomes and demand, which was boosted further by the money withdrawn from the second pension pillar and by increased state spending. Money to the value of some 7% of GDP has been added into the economy in the past two years through budget deficits and funds from the European Union. Having come close to the limits of production capacity by the end of last year, the economy had to start reacting to buoyant demand through higher prices.

Tightening monetary policy will curb inflation. The Governing Council of the European Central Bank has announced that it plans to raise base interest rates from July to bring inflation in the euro area back to close to 2%. Interest rate rises will be transmitted through Euribor into higher prices for loans to households and companies in Estonia, but it will take time for the cooling impact of this to reach the Estonian economy and inflation. As there are several domestic factors behind high inflation in Estonia, the state needs to limit its spending of borrowed money in order to restrain inflation.

If the state cannot find the funds needed to ease the impact of the sharp rise in the cost of living, then accurately targeted support would work better. The sharp rise in spending on essentials will hit those on lower incomes much harder, and so the state could provide well-targeted aid to those who need it the most. Broad and evenly-spread subsidies or tax cuts would actually cause inflation to rise higher under the current economic circumstances if they are not covered from sources in the budget. The current forecast is that energy will remain expensive for a long time, and so tax cuts or general subsidies that last for the same duration would increase the budget deficit, which is already deep, for a long time, and taxpayers would have to pay it off in the future to bring the revenues and expenditures of the state into alignment.

Additional information:
Viljar Rääsk

Head of Communications
Eesti Pank
6680 745, 5275 055
Email: [email protected]
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