The full impact of the energy crisis on the economy is only beginning to emerge

Estonia's economy has been in better than average condition so far. Despite the rapid increase in the cost of living, consumer reaction to high prices remained modest until autumn, and consumption increased both measured in euros and in quantity. Despite a significant drop in confidence, people were willing to go along with the brisk price hikes made possible by pandemic savings and money withdrawn from the second pension pillar. Most of these savings have already been used by now. Strong consumption has enabled companies to increase profits even in an environment of rapidly rising costs.

The impact of rapid price increases on economic growth is becoming more and more apparent. At the end of the past year and in the first half of the new year, reduced purchasing power and reduced savings will lead to a decrease in consumption, and the profitability of companies will also suffer. This year, the volume of the economy will decrease by 0.5%, but next year the economy will grow by 0.4%, mainly due to the increasing spending of the government sector. Economic growth can be expected to accelerate to 3-4% in 2024-2025, but due to the war, both price and economic growth prospects are more uncertain than usual.

Inflation is persistently receding. Permanently high energy prices and the increase in the price of goods and services necessary for production have not yet been fully passed on to end consumers, so the price increase is slowing down, but gradually. Despite the drop in prices of food commodities on the world market, the share of food products in the general price increase will increase in the near future, as food production, which is more affected by the energy crisis, is still passing through the price peak in Europe. The price increase will be slightly below 20% this year, will decrease to below 10% next year, and is expected to be between 2-3% in 2024-2025.

A cooling economy increases unemployment. The decreased desire of companies to recruit is reflected in the indicators of the labor market, and employment will decrease in 2023. Unemployment will peak at around 9% in 2024, and part of the increase in unemployment is related to the fact that Ukrainian war refugees seeking employment in Estonia will begin to be reflected in labor market statistics. Wage growth will remain close to 8-9% in the next two years, and it will be boosted by the increase in the minimum wage, public sector wage agreements and price increases. The purchasing power, which fell by 9% in 2022, will recover by the end of 2025.

The tightening of monetary policy restrains the price increase more and more. The Council of the European Central Bank has gradually increased monetary policy interest rates during this year. Therefore, loans are becoming more and more expensive for bank customers. Euribor raises the price of borrowed money for people and companies, thereby cooling the economy and, above all, the price growth of industrial goods and services. The rise in interest rates is steep, but the Euribor is still expected to remain lower than it was on average before the 2008 financial crisis. The higher loan interest than before is more in line with the growth of consumer and asset prices in Estonia and helps mitigate the risk of overheating in the real estate sector.

A rapid price increase will improve this year's budget position, but increase the deficit in the following years. In the last year, the rapid price increase has increased the collection of tax revenues, but the price increase will be transferred to many state expenses from the new year. In 2023, the budget deficit will increase by leaps and bounds, as it will be exacerbated by several decisions coming into effect in 2023: the increase in family allowances, the increase in income tax relief and the extraordinary increase in pensions and tax relief. In the next three years, the deficit will remain above 3% of GDP, and the debt burden of the government sector will increase. The later and with a higher debt burden, the fiscal discipline is restored, the more extensive the increase in the tax burden or limiting the growth of expenses is necessary to achieve this.

In the state budget, it would be reasonable to maintain a balance between supporting people and companies and reducing inflationary pressure on the other hand. The energy crisis, war refugees and increasing defense readiness require additional spending from the government, but the budget will be in a deep deficit in the coming years even without emergency spending. The biggest problem for the economy so far ― expensive energy prices ― will remain until the supply-side problems are alleviated. This will take years, during which the state can provide additional assistance to those who need it most. The increase in energy prices affects people with different income levels and different economic sectors with different strength, and therefore, from the point of view of managing the general price increase, it is important that the additional state aid is precisely targeted and temporary.