With growth strong after the pandemic, we must not overlook the risk of overheating, says Ülo Kaasik
“The Estonian economy suffered less from the pandemic crisis than the average in the euro area and it has by now already expanded beyond its pre-crisis size. Under these circumstances the state does not need to provide additional support, and doing so could give an excessive boost to demand and so to inflation. The state should be aiming to bring its revenues and expenditures into balance more quickly”, the Deputy Governor of Eesti Pank Ülo Kaasik told the annual meeting of the Estonian Economic Association.
The June forecast from Eesti Pank predicts that the Estonian economy will grow by 5% this year and that growth may pick up to above 8% if the negative impact on the economy of the coronavirus restrictions in the spring proves smaller than calculated. The economy was already larger in the first quarter than it was before the crisis and businesses in almost all sectors are optimistic. “Estonia has on average done very well and the economy is back on a path of strong growth, close to potential”, commented Mr Kaasik, noting though that signs of the risks of overheating are already apparent in places, and Eesti Pank is monitoring them carefully. There are however sectors of the economy that continue to be seriously impacted by the crisis and where recovery is only just starting.
Strong growth has been accompanied by higher inflation. This is affected by factors from outside Estonia, as the Estonian economy is small and very open. Prices of various raw materials have risen notably on global markets as supply has not been able to keep up with the rapid increase in demand as restrictions have been eased. The growth in demand has been encouraged by large-scale economic stimulation programmes in several countries. Businesses are feeling inflation primarily through rises in prices of various production inputs, and a rapid rise in prices for construction products have also been observed. Consumers are feeling it most through higher energy prices. Demand in the Estonian domestic market is also adding price pressures. Consumption is being boosted by the additional savings that were built up during the pandemic and that total over a billion euros, and will be boosted further in the autumn by the money withdrawn from the second pension pillar.
Ülo Kaasik stated that the central bank is not yet very concerned about the rate of inflation, as several of the causes of it are most probably only temporary. The blockages in supply chains for example will have less impact once companies have adapted to them. Equally, the effect of the low reference base for energy prices that was a consequence of the pandemic will also disappear. Commodities prices have historically been very volatile. The European Central Bank forecasts that inflation in the euro area, which has already risen to 2%, will come down again in the coming year. “Inflation in the euro area may temporarily exceed 2% in the second half of the year, but after that it is expected to be in the region of 1.5%, as the rapid rise in commodities prices will ease according to market expectations and some commodities prices may fall”, said Mr Kaasik. Prices for wood are already coming down for example.
Inflation is higher in Estonia as the standard of living and the price level in Estonia are still catching up with those in the wealthier countries of the euro area. Prices in Estonia, unlike those in the euro area on average, fell across the board during the pandemic, and so a stronger post-crisis rebound is now apparent. There may be additional price pressures in the near term if people hurry all at once to spend their savings and demand exceeds supply in some sectors. The state, as one of the most important actors in the economy, can influence how much additional demand is generated through state budget expenditures. “It would be wise not to use the state budget to increase demand excessively and so push inflation higher”, said Mr Kaasik. Excessively high inflation and consequently higher wage demands could put the competitiveness of Estonian companies at risk, and a deterioration in that could hurt both the creation of new jobs and wage growth. “With the economy growing fast and revenues good, it is the right time for the government to aim at reducing the state budget deficit faster”, noted Mr Kaasik.
With the economy growing fast and revenues good, it is the right time for the government to aim at reducing the state budget deficit faster
The economic outlook in the euro area as a whole is also generally positive although countries are emerging from the pandemic very unevenly. “Not everybody has done as well as Estonia”, pointed out Mr Kaasik. The European Central Bank forecasts that some countries will only reach their pre-crisis level in 2023, and uncertainty around the pandemic still remains. In consequence the European Central Bank decided at its last monetary policy discussion that the euro area will continue to need strong monetary policy support. The inflation forecasts for the euro area also encourage the assumption that the European Central Bank will keep interest rates low.
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