• The economy is in its best position since the crisis
• The economy will grow more slowly in the years ahead, as the strong growth in foreign markets is fading and available production capacity in the economy is becoming exhausted
• The government is giving an additional boost to an economy that is already growing fast; a looser fiscal policy means that the state can provide less support if the economy should take a sudden turn for the worse
• No serious shocks to the economy from within Estonia are foreseen, but the dangers from Estonia’s exposure to the rest of the world are large

The Estonian economy has been gaining in strength throughout 2017. Output volumes grew in most sectors in the third quarter and total output in the economy was 4.2% more than a year earlier. The economies of Estonia’s main trading partners and other countries in Europe have grown more than was previously expected, and this has given a boost to the Estonian economy as well. It is forecast that Estonian economic growth for 2017 as a whole will exceed 4%, which is the fastest rate of the past six years. The economy will also grow by more than 4% in 2018, but then growth will slow as the boost from foreign markets fades and production capacities approach their limits.

Strong demand in Estonia and in foreign markets has pushed the Estonian economy above its long-term sustainable level. Although it is not possible to measure long-term sustainable growth or the consequent size of the economy directly, low unemployment, a rise in the number of unfilled vacancies, increasing labour shortages, strong wage growth, and rising inflation all indicate that the economic cycle has reached a point where growth is being driven mainly by demand, not by increases in the production capacity of companies or in labour productivity. Productivity has grown a little faster in the past year, but the rate of growth is still lower than in the previous decade.

Productivity is increasing gradually as companies have started to invest more. As financing conditions will remain favourable in the coming years and companies find themselves under heavy pressure to raise wages to remain competitive as employers, investment will increase to raise the value added created by each person employed. Exporting companies and other companies that are exposed to foreign competition are in a better position than they have been in previous years, as prices are rising faster in international markets, allowing production costs to be passed into end prices more easily. The consequence is that profits have increased in the corporate sector and opportunities to raise productivity through investment have improved.

Upward pressure on wages will be weaker in the near future, but only for the time being. Pressure will be eased in 2018 by the income tax reform and smaller rises in the minimum wage than earlier, though in subsequent years wage competition will start to increase again. Although labour costs have risen strongly for a long time now, the wage level in Estonia is still only about half of the European Union average, and as large differences remain in income levels, so upwards pressure on wages will remain. It is hard to fill vacancies in low paid jobs as they are not competitive in the labour market.

The current state of the economy does not yet indicate overheating, but the danger is certainly present. Unlike 10 years ago, the structure of the economy is not being distorted by rapid growth in debt levels. The construction industry is growing strongly however, as orders from both the private and the public sectors are increasing. Construction stands out among other sectors for its large labour shortages, which may lead to excessive growth in labour costs if orders continue, and the higher wages may tempt workers in from other sectors. The rate at which people change jobs has again reached the level seen during the previous economic boom. It is important to avoid a temporary pile up of projects and the volatility in the construction amplifying the growth cycle in the whole economy. The general government has an important role to play in achieving this.

The rapid growth in spending by the general government will boost the economy in 2018. General government investment will increase in 2018 and the changes to income tax will raise the disposable income of households, which will boost the economy as a large part of this will go into consumption. It is forecast that fiscal policy will boost economic growth until the end of the forecast horizon in 2020, as throughout this time the consolidated general government budget will be in nominal and structural deficit. As the economy is in a good position and is being stimulated by the single monetary policy of the euro area^[1], fiscal policy will be supporting the economy at the wrong time. If the state does not build up reserves during the current good times, it may be difficult for it to support the economy enough during future bad times, and stabilising growth in the economy may need increasing budget deficits to an extent that would breach the rules of Estonia and the European Union.

There is nothing evidently apparent in the domestic economy that could bring a sharp stop to growth in the economy. The main risks come from the pressure on labour costs that have been noted for some time already and that threaten the international competitiveness of companies, and from the recently emerged danger of overheating in the construction sector. Even if the rise in labour costs is based on excessive optimism however, wages are likely to adjust smoothly as the financial indicators for companies are strong enough to let them survive such pressure and they are evidently in better condition than before the last crisis. External risks are potentially more serious than domestic risks and Estonia’s openness means they could seriously harm the prospects for growth in the Estonian economy.

Inflation will fall in the coming years. Consumer prices grew at close to 4% over the year in the last months of 2017, but this will fall to close to 2% in the years ahead. Inflation will mainly fall as commodities prices rise more slowly, and it will be brought down by the contribution of indirect taxes, which will raise the cost of the consumer basket by 0.7% in 2018 but by around 0.4% in the next two years.