Eesti Pank forecasts that the full impact of the energy crisis is only starting to be felt by the economy



The latest economic forecast from Eesti Pank finds that consumption will be reduced by high inflation and that the profitability of companies will decline. The economy is expected to grow a little in the new year, mainly because of increased spending by the state. Inflation will continue to fall, and will probably be a little below 10% in 2023.

The Estonian economy has so far performed better than the average. Despite the rapid rise in the cost of living, the reaction of consumers to high prices was mild until the autumn, and consumption increased both in euros spent, and in volume. Despite the notable drop in confidence, people were prepared to keep pace with high inflation, which was made possible by the savings built up during the pandemic and the money withdrawn from the second pension pillar. Most of those savings have by now been used up. High levels of consumption have allowed companies to increase their profits, even with costs rising fast.

High inflation is now increasingly affecting growth in the economy. Reduced purchasing power and shrunken savings point to a fall in consumption volumes at the end of this year and in the first half of next, and so corporate profitability will also take a hit. The economy will shrink in volume by 0.5% this year but it will grow next year by 0.4%, mainly because government spending will increase. Growth may be expected to increase to 3-4% in 2024-2025, but the war in Ukraine means that there is greater uncertainty than usual around the outlook for economic growth and for inflation.

Inflation will come down slowly. Energy prices remaining consistently high and prices rising for the goods and services needed for production has not yet entirely been passed on to end consumers, and so inflation will fall, but slowly. Although prices of food commodities have fallen on global markets, the share of food in general inflation will increase in the near future, as food production has been affected more by the energy crisis and is only reaching its price peak in Europe. Inflation will be a little below 20% this year but will fall below 10% next year and is expected to remain at around 2-3% in 2024-2025.

Unemployment will rise as the economy cools. Reluctance by companies to hire will reach the labour market after a lag, and employment will fall in 2023. Unemployment will peak at around 9% in 2024, and a part of the increase in unemployment will be due to refugees from Ukraine looking for jobs in Estonia and starting to be reflected in the labour market statistics. Wages will rise by around 8-9% in the next two years, and this will be driven by the rise in the minimum wage, pay agreements in the public sector, and inflation. Purchasing power will have fallen by 9% in 2022 and will recover by the end of 2025.

Tightening monetary policy will curb inflation more and more. The Governing Council of the European Central Bank has raised the monetary policy interest rates in steps this year. Loans taken out by clients of banks are consequently becoming increasingly expensive. Euribor will push up the cost of borrowing for people and companies, cooling the economy and so slowing inflation for manufactured goods and services in particular. Interest rates have risen sharply, but Euribor is expected to remain below where it was on average before the financial crisis of 2008. Interest rates on loans being higher than they have been is more in line with the growth in consumer and asset prices in Estonia, and will help to reduce the risk of the real estate sector overheating.

High inflation will improve the fiscal position this year, but will increase the deficit in the coming years. High inflation has this year increased receipts of tax revenues, but inflation will pass through into a lot of state spending from next year. The budget deficit will widen sharply in 2023, as it will be deepened by several decisions that will come into force next year, including a rise in family benefits, an increase in the tax-free threshold, and an extraordinary rise in pensions and a tax exemption for them. The deficit will remain above 3% of GDP for the next three years, and the general government debt will increase. The later fiscal discipline is restored and the larger the debt is at that point, the larger will be the increase in the tax burden or reduction in expenditures that will by then be needed to achieve that discipline.

It would be wise for the state budget to maintain a balance between supporting people and businesses and at the same time reducing inflation pressures. The energy crisis, refugees from the war, and increased readiness for national defence will all cause additional expenses for the government, but the budget for the coming years was already in deep deficit without extraordinary spending. The biggest problem so far for the economy has been high energy prices, and this will remain until the supply-side problems are alleviated. This could take years, during which the state may need to give additional help to those who need it most. Higher energy prices have different effects for people with different income levels and different branches of the economy, and so it is important for additional state aid to be accurately directed and temporary to avoid provoking general inflation.

Publication: Estonian Economy and Monetary Policy 4/2022

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