Latvijas Banka has published its latest December 2022 macroeconomic forecasts for Latvia. These forecasts are surrounded by a persistently high degree of uncertainty. The baseline scenario of the forecasts remains unchanged from September and the narrative provides for a supposedly temporary and shallow recession in Latvia’s economy. However, upward inflation is over the horizon.
On account of the actual data, Latvia’s gross domestic product (GDP) growth projections for 2022 have been revised downwards to 2.1%. Nevertheless, the overall economic outlook has remained broadly unchanged, and the development in 2023 is seen as similar to the previous forecasts, projecting a 0.3% contraction. This drop in GDP growth, however, will be accompanied by a more pronounced 5.6% contraction in household consumption. Lower purchasing power will have a negative effect on the population’s welfare.
Inflation remains high, and the assumptions concerning the growth of global food prices and domestic wages have been revised upwards. That resulted in upward revisions of inflation projections over the entire projection horizon: inflation is expected to grow by 17.3% in 2022, by 10.9% in 2023, and by 4.4% in 2024. In 2025, inflation is projected at a level of 3.0%.
In response to the soaring inflation, major global central banks, including the European Central Bank (ECB), are raising their monetary policy rates. From March 2023 onwards, the ECB will reportedly start gradually reducing the asset purchase program (APP) portfolio.
Since 2015, the ECB has not significantly reduced its balance sheet at any time. And, since 2014, it has kept interest rates artificially low and negative.
In July, the ECB created a new instrument of monetary policy, the Transmission Protection Instrument (TPI), to counter the risk of fragmentation of the eurozone. The TPI is a new asset purchase program, focused on bonds of the most indebted eurozone members. this is essentially a new type of QE. In order to buy these bonds, the ECB will have to increase its monetary base.
QE, by itself, does not cause prices in the real economy to increase, but it is harmful to the economy by generating distortions in the allocation of resources, making the economy more fragile (i.e. dependent on artificially-low interest rates) and susceptible to recessions. These distortions cause resources to be wasted on unprofitable ventures, preventing the generation of sustainable ventures and reducing real wages. Here indebtedness increases and more money is spent on interest to finance the debt, instead of investing in productivity, which would tend to lower prices and increase real wages. Furthermore, QE makes the prices of financial and real estate assets artificially higher.
The rise of global food prices and wages, however, could be more pronounced and sustain higher inflation in Latvia than previously estimated. Like the Fed, the ECB doesn’t have much room to raise rates and shrink its balance sheet, unless governments significantly reduce their debts. To really get prices to pre-2021 levels, governments would have to reduce their spending, so that their indebtedness would decrease, and the ECB would not only stop expanding the monetary base to buy government bonds but also shrink its balance sheet. Which means to contract the money supply.