Mertsina: More favorable interest rates are improving economic activity

TALLINN - More favorable interest rates are improving economic activity, Swedbank chief economist Tõnu Mertsina says in his latest economic commentary.

According to Mertsina, the European Central Bank (ECB) should keep its interest rates unchanged at this week's meeting. If so, they would have remained unchanged since July of last year.

The eurozone economy is recovering, but it still faces several challenges. Last year's 1.5 percent growth was above the long-term average, but it was not broad-based - Ireland alone contributed nearly 40 percent to the eurozone's economic growth.

"Eurozone inflation already moved below the central bank's two percent target at the end of last year, and in our estimation, it will remain below that level this year as well. However, this is not yet enough for the European Central Bank to lower its interest rates to further stimulate the economy," Mertsina said.

"Although we are currently sticking to the forecast that the European Central Bank will not change its interest rates in the next two years, a euro that strengthens excessively against the dollar could change this outlook. Money markets have raised the probability of an interest rate cut by the ECB this year to 25 percent. This follows a recent warning from the head of the Austrian central bank that if the strengthening euro starts to curb inflation more than expected, a rate cut should be considered," Mertsina continued.

According to Mertsina, a stronger euro against the dollar could harm the price-based competitiveness of eurozone exports, but this effect is mitigated by the cheaper import of dollar-denominated goods. At the same time, cheaper imports contribute to slowing inflation in the eurozone.

According to Eurostat data, the year before last, the dollar's share in Estonia's exports outside the single market was 28 percent and in imports 42 percent. "Although these shares were smaller in our intra-EU trade, the combined direct and indirect impact of the dollar exchange rate is still significant. However, looking at all cross-border transactions made in Estonia, they are predominantly in euros. Last year, the share of transactions made in euros was nearly 98 percent, while the dollar's share was only around one percent," Mertsina said.

He said that ongoing significant geopolitical tensions could also affect the central bank's interest rate outlook. The first weeks of this year also showed that the trade agreement with the US may be fragile.

"The market interest rates that have come down over the last two-plus years leave households and non-financial corporations with more funds for consumption, investment, and savings," Mertsina said.

Last year, new housing loans in Estonia increased by 24 percent compared to the previous year, and corporate borrowing rose by 31 percent. However, a prerequisite for growth in consumption and investment is an improvement in confidence.

Overall confidence in economic sectors is indeed improving, including household confidence, which has been growing since the middle of last year. Thus, more favorable interest rates, alongside income tax changes and larger government infrastructure and defense investments, should have an additional positive impact on the Estonian economy this year, Mertsina added.