The escalation of the war in Ukraine and its consequences on energy market supplies will have a negative impact on the economy, which will grow more slowly. High energy prices will also keep inflation elevated longer. In the exceptional circumstances of an energy shock, it’s been told that targeted measures to help people and businesses would mitigate the negative impacts. As the downside risks arising from the war in Ukraine and the energy shock materialize, “the country’s economic growth will slow down and high inflation will become prolonged. In such an environment, we support and encourage the implementation of highly targeted state aid measures for vulnerable groups and businesses”, says Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania. How to cut market distortions then?

The war in Ukraine has significantly increased the prices of the main energy resources and food commodities. While some of these have returned close to pre-war levels, the prices of some commodities, in particular natural gas, remain significantly higher and have a particularly negative impact on economic development. The prevailing uncertainty over energy resources and soaring inflation are slowing down growth in the countries that are Lithuania’s main trading partners and, accordingly, affect Lithuania’s economy. The 2.1% GDP growth forecast by the national bank remains unchanged for this year, as a marked deterioration in the assessment of recent developments has been offset by a significant improvement in the first half of the year. However, Lithuania’s economic growth forecast for 2023 has been revised down to 0.9% (from 3.4%).

Despite slower economic growth, the labor market is still experiencing labor shortages, with unemployment down to 5.2%. In the face of labor shortages, average wages will continue to rise. Average nominal wage increases are projected at 12.7% this year and at 8.7% in 2023, provided that the minimum wage is increased by 15% next year as has been currently proposed. The outlook for consumption is clouded by high inflation, with consumers’ purchasing power falling and price increases outpacing wage growth. Annual inflation will reach 18.3% this year, but it’s been told already starting to slow down and is expected to drop to 8.4% next year.

Meanwhile, the Bank of Lithuania and Statistics Lithuania published provisional data on direct investment (DI) for Q2 2022. According to the latest data release:

• the flow of foreign direct investment (FDI) in Lithuania amounted to €709.9 million in Q2 2022. The bulk of the flow resulted from lending to direct investors (€2 billion). During the reporting period, negative reinvested earnings were recorded (€1.4 billion), affected by €2.2 billion of dividends paid to investors. The largest positive investment flows to Lithuania were observed from the UK (€479.5 million) and Switzerland (€146.2 million), while negative flows came from Hong Kong (€343.9 million);
• FDI income by non-residents amounted to €743.4 million. The largest share of FDI income was earned by the UK (€164.9 million), Estonian (€118.6 million), and Swedish (€116.4 million) investors. Over 2021, FDI income increased by 46% to €2.9 billion;
• as of 30 June 2022, cumulative FDI in Lithuania amounted to €28.3 billion and increased by 10.4%, compared with Q1 2022, accounting for 46.9% of GDP. At the end of Q2 2022, the largest investors in Lithuania included Germany (€5.5 billion), Sweden (€3 billion), and Estonia (€2.9 billion). The largest share of FDI was attracted by companies engaged in financial and insurance activities (€10 billion) and manufacturing (€4.4 billion);
• the flow of Lithuania’s DI abroad totaled €29.7 million over the reporting period. It declined 2.2 times in 2021;
• Lithuania’s cumulative DI abroad grew by 8.6% year on year and stood at €10.3 billion on 30 June 2022. Major directions of Lithuania’s DI abroad: the US (€4.3 billion), Latvia (€1.7 billion), and Estonia (€1.3 billion).

Despite the optimistic forecast of slowing-down inflation, the repercussions of the war in Ukraine and its further developments are bound to have a major impact on the Lithuanian economy in the coming years. The nature of this factor means that EU countries’ economic outlook is currently shrouded in extreme uncertainty. Significant volatility in energy commodity prices, especially natural gas, is adversely affecting the sentiment and expectations of both households and businesses, leading to more cautious household consumption and undermining companies’ willingness to invest.

In September, the ECB raised interest rates for the second time this year (by 0.75 percent), whereas the eurozone’s CPI was 8.9 percent in July. In that month, the ECB raised rates by 0.5 percent and created a new instrument of monetary policy, the Transmission Protection Instrument (TPI), to counter the risk of fragmentation of the eurozone. The PTI is a new asset purchase program, focused on bonds of the most indebted eurozone members. This is essentially a new type of QE since in order to buy these bonds, the ECB will have to increase the monetary base. It remains to be seen if the increase in the monetary base arising from this program will be accompanied by a significant increase in M1 and M2, which are the monetary aggregates that really influence prices in the real economy.

Under the circumstances, the Bank of Lithuania welcomes measures to assist the population and businesses provided they are in line with these principles:

• targeted assistance is provided to vulnerable groups and businesses;
• assistance reaches its beneficiaries automatically if their living or working conditions deteriorate below certain established criteria;
• the assistance measures do not unduly reduce incentives for the economical and rational use of energy resources;
• public funds supposedly won’t create excess demand leading to higher inflation;
• the measures adopted will accelerate the economy’s transition to renewable energy sources in the long run and reduce dependence on fossil fuels.

QE, by itself, does not cause prices in the real economy to increase. It is harmful to the economy by generating distortions in the allocation of resources, making the economy more fragile (more dependent on artificially-low interest rates) and susceptible to recessions. These distortions cause resources to be wasted on unprofitable ventures (such as zombie companies), preventing the generation of sustainable ventures and reducing real wages, 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 purpose of the PTI is to mitigate the eurozone’s fragmentation risk, lowering the probability of the most indebted countries’ exit from the eurozone (returning to the national currencies and expanding the money supply to finance the government debt). The PTI, therefore, is an unofficial form of yield curve control. The PTI’s goal is to lower interest rates (mainly the ones of the most indebted members), if necessary. The instrument also has some eligibility requirements that are supposed to be followed by eurozone members in order for the ECB to buy their bonds under this program. However, if governments really followed public debt sustainability rules, the PTI wouldn’t even need to exist.

It looks like the ECB is being a little less expansionist on the one hand (by making slight increases in interest rates in relation to the high CPI) and may be expansionist on the other (by creating the PTI). The fact that the ECB’s balance sheet has stopped increasing and that eurozone’s M2 is increasing at a slower pace than in 2020-21 are factors that reduce the pressure on price increases. But, in the best case scenario, the ECB will be able to bring the CPI to lower levels. It is less likely that prices will return to pre-2021 levels, as this would require price deflation. 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. Artificially-low interest rates are not the only inflationary factor.