Bank of Latvia published its latest June 2023 macroeconomic forecasts drawn up amid persistently high uncertainty. Hope dies last, and rhetoric is as persistent as core inflation (excluding food and energy prices).
Latvia’s inflation projections for 2023 and 2024 have been revised downwards to 8.5% and 2.4% respectively. For 2025, inflation has been revised slightly upwards – to 3.0%. The gross domestic product (GDP) growth forecast for 2023 has been revised upwards to 1.2% while it is revised downwards to 3.1% in 2024. The GDP growth forecast for 2025 is 3.5%.
Inflation in the euro area is proving to be more persistent than previously expected despite falling energy prices and easing supply chain bottlenecks. That’s why major global central banks, in response to the high inflation, continued raising interest rates since the previous forecasts.
With global energy and food prices decreasing, it is expected that headline inflation in the euro area will continue on a downward path. However, core inflation will be more persistent in combination with increasing labour costs and stronger demand in the services sector.
In the light of inflation outlook continuing to be too high for too long, the Governing Council of the European Central Bank (ECB) has decided to continue raising interest rates by 25 basis points in May and June respectively. The hope is to bring the key interest to levels sufficiently restrictive to achieve a timely return of inflation to the 2% medium-term target.
The steep fall in energy prices reduces inflation in Latvia, and global energy prices are expected to be lower than previously estimated. Annual inflation in Latvia continues decreasing on a monthly basis, i.e. from inflation rates exceeding 20% early this year to 12.3% in May, and it is expected that will decline to single-digit levels in the second half of 2023.
Electricity prices and the administratively regulated heat energy and water supply tariffs also decrease in Latvia along with a drop in global energy prices. Lower natural gas tariffs for households also reflect growing competition in Latvia’s natural gas market. Higher tariffs on electricity transmission and distribution services will take effect as of July but are supposed to leave the outlook for inflation unchanged since they were already included in the previous forecasts as pending.
On the other hand, the Bank of Latvia reiterates how the previously-observed high inflation and a tight labour market, which increases the wage negotiation power of employees, are reflected in steeper wage growth. Low unemployment entails an advantage for employees to request wage growth to maintain their purchasing power.
In fact, wages already edged up by 12% in the first quarter, reflecting a rise in the minimum wage and partly compensating for the impact of inflation. The tight labour market increases the risk that inflation will remain higher and growth lower.
The second-round inflation risks intensify: if employees request higher wages to compensate for inflation on the basis of high inflation expectations and businesses offset the sharply increasing labour costs with price rises, inflation may remain higher than the desired rates for an extended period of time. Such a wage-price spiral, which is not being taken into consideration in the Bank’s forecasts, would significantly harm competitiveness and the economy as a whole.
Currently, inflation expectations are decreasing, and government support is intended to be more targeted to avoid fuelling inflation. As lower government support expenditure and higher economic activity are envisaged, the general government deficit is expected to gradually fall from 3.8% of GDP in 2023 over the coming years.
An earlier-than-projected depletion of savings for purchases will limit consumption growth in the coming quarters. Faster upswing in consumption is expected to begin only in 2024 when inflation rates moderate, and Latvia’s economic growth will also accelerate in 2024–2025. Hope dies last.
In a scenario where demand forecasts in the main trade partners – Estonia and Lithuania – hamper Latvia’s economic growth, uncertainty prevails in the region. And the rising borrowing costs are weighing on investment growth. The role of EU funds is increasing amid uncertainty. However, the implementation of projects has experienced delays so far.