Central Bank: Economic recovery to be more subdued than expected

TALLINN - While the Bank of Estonia had forecast economic growth of 3.6 percent for this year back in December, faster price increases, the resulting slower growth in purchasing power, and greater uncertainty due to the energy crisis have collectively lowered Estonia's economic growth forecast for this year to 2.8 percent.

According to the Bank of Estonia, the growth environment for the Estonian economy continued to improve at the beginning of the year. The impact of the new energy crisis has not yet been reflected in statistics on economic activity, but various indicators confirm that before the outbreak of the conflict in the Middle East, the Estonian economy was clearly on a path to recovery.

In the main sectors - construction, services, retail, and manufacturing - companies' production and employment expectations were trending upwards until early March, reflecting increased confidence in future growth. Over the past two years, the sales volume of goods has grown in both domestic and foreign markets, and exporters' assessments of their products' competitiveness saw a notable jump at the end of last year. The improvement in goods exports and the manufacturing industry that supports it has played a major role in emerging from the downturn caused by previous crises.

According to the central bank, the outlook for the global, European, and Estonian economies depends largely on the course of military actions in the Middle East and the resolution of the resulting energy crisis. Energy prices rose after the attacks on Iran, which in turn also increased the prices and price forecasts for other key commodities. The expectation of accelerating inflation also pushed up interest rates in money market futures.

While the Bank of Estonia forecast 3.6 percent economic growth for this year in December, markets now expect faster price and interest rate hikes due to the energy crisis. The faster price increase, the resulting slower growth in purchasing power, and the greater uncertainty associated with the energy crisis will collectively lower Estonia's economic growth forecast for this year to 2.8 percent. However, as events in the energy market affect the economy and are simultaneously unpredictable for geopolitical reasons, it is likely that the actual performance of the economy will differ from this forecast in terms of both prices and economic growth.

This year's economic growth is driven by domestic demand, as both consumption expenditure and investments are increasing. The largest increase will be in state defense investments, the majority of which consists of imported goods. Therefore, the money spent on this will flow out of Estonia and not directly contribute to economic growth. However, the amendment to the Income Tax Act will strongly affect people's purchasing power and ability to consume.

The average gross monthly salary will rise by approximately 6 percent this year, but the average net salary will increase significantly more, by about 10 percent, due to a lower effective tax rate. This means that even accounting for inflation, real income will increase significantly, which in turn will stimulate consumption and the economy as a whole.

The increased cost of energy due to the war in the Middle East and its indirect effects will keep inflation faster than it would have been otherwise. The price of oil has fluctuated rapidly since the start of military activities in the Middle East, and the uncertainty in the energy market is a significant source of forecast error, as changes in the price of oil are passed on to the prices of other goods and services.

Compared to the 2022 energy crisis and the price spike at that time, the pass-through of the oil price increase to gas and electricity prices is more modest for European countries due to the diversification of suppliers, as confirmed by available data. This reduces the impact of rising oil prices on the entire consumer basket. At the time the forecast was prepared, futures contracts on the oil market indicated that markets expect oil prices to start declining in the second half of the year. If this market assumption holds true, inflation in Estonia would reach 3.8 percent in 2026 and just over 2 percent in the following two years.

The budget deficit and public debt are increasing, which raises the state's annual interest payments. The increase in defense spending to more than 5 percent of the gross domestic product (GDP) and the decrease in revenue resulting from the income tax law amendment are the main factors that will increase the general government budget deficit to 4.4 percent of GDP this year. If the government and parliament do not change course, the deficit will remain at a similar level for the next two years.

Although Estonia's public debt level remains low by international comparison, the Bank of Estonia is concerned about the continued rapid growth of debt. Considering the long-term outlook for Estonia's security, its demographic situation, and rising interest costs, serious consideration should be given to how to return public finances to a sustainable path and slow the growth of the debt burden. In the case of a large and persistent budget deficit, new decisions should bring the budget closer to balance, not further away. Moreover, according to the central bank, tax policy decisions should be well-considered, explained in advance, sustainable, and supportive of economic growth.