The Estonian economy started the year in a very strong position, but growth would have slowed substantially this year even without a new crisis. Production resources were already running at full capacity by the end of last year, and deepening supply-side restrictions had started to get in the way of continued fast growth. The outbreak of war in Ukraine in February overshadow the outlook for the Estonian economy further, through the disappearance of some export markets, the interruptions to supply channels, and the rise in the price of commodities. While sanctions on Russia have already led to rapid price rises, the broader impact on the economy will only start to become apparent in the second half of the year. The time to cut the money supply ios now.

Data from the Bank of Estonia show that inflation remained high in May, touching 20% over the year. The price level was 1.9% higher than in the previous month. The biggest impact came from higher prices for electricity and motor fuels. Inflation in Estonia has been the fastest in the euro area in recent months, mainly because of the major rise in energy prices. Higher energy costs will gradually be passed through into the prices of many other goods and services. That high inflation has allowed companies to raise prices faster than their costs have risen is shown by the strong growth in profits. The increase in profits also means that average growth of 10% in wages is not yet proving very painful for companies. As future transactions for gas, electricity, and oil show no sign of prices falling soon, the price level of the consumer basket will remain high for a longer time than was earlier forecast.

“Inflation is always and everywhere a monetary phenomenon” (Milton Friedman). That inflation is twice the average in the euro area can be explained not only by rising energy prices but also by the rapid growth in Estonia in incomes and demand, which was boosted further by the money withdrawn from the second pension pillar and by increased state spending. Money to the value of some 7% of GDP has been added to the economy in the past two years through budget deficits and funds from the EU. Having come close to the limits of production capacity by the end of last year, the economy had to start reacting to buoyant demand through higher prices.

Tightening monetary policy is expected to curb inflation. The Governing Council of the ECB has announced that it plans to raise base interest rates from July to bring inflation in the euro area back to close to 2%. Interest rate rises will be transmitted through Euribor into higher prices for loans to households and companies in Estonia, but it will take time for the cooling impact of this to reach the Estonian economy and inflation. As there are several domestic factors behind high inflation in Estonia, the state needs to limit its spending of borrowed money in order to restrain inflation. And it needs to start now.

Another signal comes from the flash estimate, which put the Estonian current account at 252 million euros in deficit in April 2022. Exports of goods were up over the year by 13% and imports by 28%, and so the deficit in the goods account increased by 246 million euros to 389 million. Imports have recently been driven most by imports of mineral fuels and of metal products, which have risen rapidly in price. Services exports were 12% more than a year earlier and imports were 2% more. The surplus on the services accounts increased by 71 million euros to 167 million. The biggest growth in exports and imports of services was in transport and travel services. The current forecast is that energy will remain expensive for a long time, and so tax cuts or general subsidies that last for the same duration would increase the budget deficit, which is already deep, for a long time, and taxpayers would have to pay it off in the future to bring the revenues and expenditures of the state into alignment.