Responsible fiscal policy would help keep faster inflation in check
The latest economic forecast from Eesti Pank finds that the Estonian economy has exited the crisis very powerfully. Although some sectors have not recovered yet, the economy as a whole has clearly returned to its pre-crisis level. Inflation is temporarily high in Estonia for various reasons, and it would help to bring it down if the government did not substantially increase its spending in the coming years. Inflation remaining high for a long time could damage people’s purchasing power and the competitiveness of the exporting sector, on which job creation and long-term wage growth depend.
“The central banks of the euro area, including Eesti Pank, affect price developments by setting policy for the euro area as a whole. If inflationary pressures in the Estonian economy are higher than the average in the euro area, it is the government that holds the tiller to steer Estonia’s local inflation rate. The government and the parliament can decide how much of the state budget can be put into the economy through spending and so drive inflation”, said Governor of Eesti Pank Madis Müller, who is also a member of the Governing Council of the European Central Bank.
The Estonian economy has recovered very rapidly from its crisis. Economic growth over the year was 12.9% in the second quarter, and the economy is forecast to grow by 9.5% for the year as a whole. The total size of the economy declined by around 3% last year, but by now it is clearly larger than it was before the pandemic. This has been made possible because of very strong growth in the branches of the economy that coped best with the difficulties, like information and communications, transport, construction and various services, while the sectors that suffered most, like accommodation and food service, leisure, and administrative and support activities, have not yet returned to where they were before the pandemic. The structure of the economy changed during the pandemic and some of the change may prove lasting, as people who have moved into employment in a different sector may not return to their old sectors as the economy improves further.
The economy will continue to perform better than usual. Demand for products and services will remain extraordinarily large in the years ahead. This demand will be driven by rapid rises in wages, the savings built up during the pandemic, the money withdrawn from the second pension pillar, and the more assured performance of the international economic environment. Output has so far mainly grown because the number of hours worked per employee has risen. More people will start being hired in the second half of the year in order to raise output volumes, and unemployment will fall by 2023 to its pre-pandemic level. The active labour market will keep wages rising rapidly this year and next, and movement between jobs will probably increase.
Prices are being pushed up in Estonia by a wide range of various causes. Higher energy prices raised inflation to 5% in the middle of this year. Even if energy prices do not rise any further, they will still continue to affect inflation until the low reference base for energy prices passes out from the data in the coming year. Prices are also under pressure because companies are finding it hard to increase production at the same rate that demand is increasing, as not only do they face labour shortages, but production capacity is also almost fully utilised already, and the investments needed to expand capacity will take time. Problems in supply chains, shortages of materials, and rising prices for raw materials continue to pose problems globally, and they are also raising consumer prices. Inflation is further being boosted by rapid growth in wage costs in Estonia. The central bank currently assumes that many of the factors causing high inflation will prove temporary, and so inflation will come down next year to 3.6%. Even so, inflation that is clearly above 3% is still much higher than the rates of inflation seen in Estonia in recent years.
It would be wise to bring the state budget into balance by 2023 to help check inflation and so maintain people’s purchasing power and the competitiveness of exporting companies. Rapid growth in the economy and in prices brings more tax revenues into the state coffers than usual, and this allows very well-targeted additional spending to be made. The Estonian economy in the years ahead is expected to be in a state where it does not need any overheating from the government, as that would raise inflation from its already high levels, so reducing purchasing power and damaging the competitiveness of exporters. Funding from the European Union will allow Estonia to make additional investment and spending in 2022-2023 of 3 billion euros in total, which is not included in the calculation of budget balance but has the same economic impact as additional investment made with borrowed money. Increased tax revenues will, however, allow a faster escape from the budget deficit. The current strong growth in the economy will allow nominal fiscal balance to be achieved in 2023 without the general government cutting spending. This only needs the growth in spending to be limited. It is important to achieve balance rapidly so that the Estonian economy would in future be able to resist any unexpected shocks, which are always a possibility.
“The state budget increased in size during the pandemic very sharply because of the spending on support measures. There is no way to increase spending rapidly in the coming years from this high level without the gap between revenues and expenditures becoming too wide. It can be foreseen though that government expenditures by 2023 will be some 30% more than they were in 2019 before the pandemic, which will clearly allow the state to make additional contributions in many areas”, said Governor of Eesti Pank Madis Müller.
Eesti Pank will publish the full forecast together with a review of the economy on 29 September.
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