High energy prices significantly hamper economic activity, and the baseline scenario of Latvijas Banka’s forecasts provides for a recession. GDP contracted already in the second quarter, and it is estimated that the second half of this year and the beginning of the next year will see an even stronger slowdown of economic growth and energy resources. Only thanks to the very high economic activity in the first quarter, the GDP forecast for 2022 points to a relatively high growth (3.0% in 2022).

Since the global financial crisis, the average wage growth in Latvia has been much more moderate (below 10%) and a far less important factor in the current surge of inflation, explaining about 3 percentage points off headline inflation. However, the increase in global energy and food prices plays a much more prominent role: it contributes almost 13 pp to headline inflation. After the pandemic, mobility and business restrictions were lifted, and households were in a rush to spend their savings accumulated during the pandemic. However, the capacity of businesses to meet the soaring demand was severely limited after the pandemic. As a result, inflation quickly gained momentum. And the post-pandemic recovery coincided with Russia’s invasion of Ukraine. The war in Ukraine further aggravated the shortage of energy resources in Europe, but the associated risks to the food supply have driven the prices of global food commodities to unprecedented high levels. Therefore, in the post-pandemic period, the dynamics of inflation in Latvia are characterized by two important factors:

• the steep recovery of demand, which was not matched by the supply;
• the very limited supply of energy resources in Europe.

The decline in economic activity will be fuelled by the fall in private consumption triggered by the deteriorating purchasing power of the population. The decrease in private consumption will be partly mitigated by government support measures and by spending the savings accumulated during the pandemic. The increased costs and investor cautiousness will have a negative impact on investment dynamics, while public investment related to EU funds is expected to grow sharply in 2023–2024. The fall in exports of goods and services will be driven by both weak demands in trading partner countries due to the declining purchasing power and the already stocked European warehouses. Imports of goods into Latvia will also be reduced by the overstocked warehouses. It was due to stockpiling that the ratio of imports to GDP reached a new record in the first half of 2022, and it will start to decline in the future. The drop in imports is estimated to be more significant than the decrease in exports. This will presumably reduce the current account deficit in 2023–2024.

With the impact of adverse factors persisting at the beginning of 2023, next year the Latvian economy will experience stagnation. Cautious household spending and the postponement of the implementation of investment plans in the corporate sector are still projected to persist. Thus, the forecast for 2023 has been revised downwards to –0.2%. The degree of uncertainty surrounding the GDP forecasts remains high. The competitiveness of manufacturers, in particular, that of European manufacturers compared to the rest of the world, may deteriorate due to higher costs. At the same time, investment in reducing energy dependency on natural gas and enhancing energy efficiency can make a stronger contribution to the financial stability of the population and businesses.

Inflation is expected to be higher over the projection horizon. The forecast for 2022 has been revised upwards to 16.9%, and to 9.2% for 2023. The increase is also affected by a higher increase in average wages projected against the backdrop of a tight labor market. The uncertainty surrounding inflation is mainly caused by energy price fluctuations. They affect the level of consumer prices for these products directly and, given the role of energy in the production and supply of different goods and services, they will eventually be incorporated in the prices of other goods and services as well.