Monetary policy tightening has allegedly helped reduce inflation in the euro area, allowing the Governing Council of the ECB to decide to lower the key interest rates by 25bp. According to the latest projections, inflation is expected to be approximately 2.5% this year and it will continue declining in 2025, approaching the 2% target.

At the same time, the ECB decided to advance the normalization of the Eurosystem’s balance sheet by reducing its portfolio of the pandemic emergency purchase program (PEPP) by 7.5 billion euros per month on average over the year’s second half. Reinvestments under the PEPP are thought to be discontinued at the end of 2024.

In Latvia, inflation has reportedly been low over the first months of the year. Data from the past few months have been slightly weaker than projected last March. Nonetheless, given the rise in natural gas futures prices, the Bank of Latvia has maintained its inflation forecast for 2024 at 1.5%.

During the first months of 2024, electricity and heat supply prices declined, while prices for various services, including the administratively regulated prices, increased. In addition, indirect taxes were raised in this period. Meanwhile, prices for food and industrial goods fluctuated in certain months due to price volatility resulting from sales.

Over the next two years, inflation is officially projected to stand at roughly 2% (2.1% and 1.8% in 2025 and 2026 respectively). As the impact of energy prices on the average price rise is supposed to diminish, domestic factors are becoming more influential in driving price developments thus questioning the institutional narrative.

First of all, amid wage increases that substantially outpace productivity, Latvia’s labor market remains tight. Wages are expected to sustain growth of over 7% also in the medium term. These wage increases will contribute to a situation where the core inflation rate (3%–4%) remains persistently higher than the headline inflation.

Second, the poor performance in exports is attributed to the weakness in the export market, instead of focusing on the decline in competitiveness. Concerns remain as relatively steep wage increases, exceeding those of Latvia’s trade partners and outpacing productivity growth, are weakening the cost competitiveness of exporters, making it more difficult to maintain and expand their market shares.

How could growth be then allegedly sustained by investments and exports? In fact, with no real “productive” argument, the narrative keeps focusing on aggregate demand and private consumption. Naturally, the latter is supported by government spending.

In fact, with estimates suggesting lower levels of private consumption and investment, the forecast for 2025 has been revised downwards. Meanwhile, the budget deficit is projected to widen. With government funding for compensating employees being increased, the overall expenditure is expected to grow at a faster rate. That’s why, over the next years, the government debt will be higher than previously projected and will follow the previous upward trend.