The outlook for the Estonian economy depends above all on the future rate of inflation. Estonia has the highest inflation in the euro area, and so the rise in production costs and in the cost of living are putting notably heavier pressure on the resilience of the national economy.
The central bank is forecasting that inflation this year will be around 19%, mainly because of higher energy costs. Inflation is expected to fall to close to 7% next year, and to 2% in 2024. The inflation forecast takes account of the European Central Bank tightening monetary policy, which will make borrowing more expensive. The government is also planning to regulate energy prices, which will bring overall inflation down to some extent.
Inflation will affect growth in the Estonian economy more strongly in the second half of this year, when it will pull it into recession. The Estonian economy was performing better than expected in the first half of this year. The supply problems that were expected as a consequence of the sanctions imposed on Russia for its military aggression remained smaller than feared, and consumption increased despite the sharp rise in prices.
Consumption has increased strongly because savings have been used to fund it, but savings will not be able to provide the same sort of support in the future. Consumption is consequently expected to decline in the near future. For the year as a whole the economy will probably shrink in size by 0.5%. It is expected to grow by around 1% next year though, and growth will then increase to some 3.5% in 2024. Geopolitical instability means that there is greater uncertainty than usual around the outlook for economic growth and for inflation.
The labour market will continue to do quite well despite the recession. Wage growth will remain strong this year and next even as the labour market cools a little, since there will continue to be a shortage of labour and both the minimum wage and prices will rise.
The average gross monthly wage will rise very fast this year and next, by more than 10%, but the purchasing power of real wages will only recover its level of 2021 at the end of 2024. Unemployment is expected to remain around 6.5% this year, and should rise to 8.6% next year. The forecast assumes that a substantial part of the increase in unemployment will come from the addition to the labour market statistics of refugees from the war in Ukraine who are looking for work.
Estonian economy is very open, and so the performance of the exporting sector is important. The weak position of export markets will be compounded by the impact of sanctions on trade and production, which will hinder economic activity. Export orders are already down, and it is important that businesses in Estonia not lose competitiveness against those in foreign countries at a time when the whole of Europe is offering packages of assistance to help cope with the energy crisis.
The European Central Bank will raise interest rates, and that will start to restrain inflation. The Governing Council of the European Central Bank has raised monetary policy interest rates to bring down inflation in the euro area, and the current assumption is that it plans to raise them further in future. The consequence is that the rising Euribor will push up the cost of borrowing for Estonian households and companies too, cooling the economy and so slowing inflation for manufactured goods and services in particular.
It should be noted though that the effect of rising interest rates is only felt in full in prices after about a year, and in any case, inflation cannot be brought under control through monetary policy alone. A major cause of high inflation in Estonia and in the euro area as a whole is the problems on the supply side, especially that of the price of energy rising several times over.
Fiscal policy has an important role to play in reducing price pressures. Given a recession caused by higher energy prices, increased state spending will not resolve the problems facing the economy but will add further momentum to rising prices. Easing the energy crisis temporarily and resolving it over the long term will need additional spending by the government, as will receiving refugees from the war and strengthening national military defence.
The budget is deep in deficit though even without those extraordinary expenses and despite tax revenues growing very fast. If Estonia remains on the same course, the fiscal deficit will deepen in the coming years and will encourage inflation to rise further.
Core inflation in Estonia without energy and food prices has exceeded 10% over the year in recent months.
Core inflation in Estonia is the highest in the euro area, and it is affected directly by fiscal policy and the amount of consumption within the economy. This means there is a danger that the competitiveness of Estonian companies may start to be reduced not only by high energy prices, but also by additional price pressures resulting from the choices made for the state finances.
Eesti Pank will publish a full version of the economic forecast for 2022-2024 on 28 September.