Inflation is rapidly receding – the price increase in Latvia will decrease from 9% this year to 2-2.5% in the coming years. The European Central Bank (ECB) will raise rates in September, but in April next year, when concerns about the sustainability of inflation in Europe will have subsided and the economy will be weak, rates will begin to decrease. The cost of living and the aggressive monetary policy slow down the economy of both the world and Latvia. However, there are differences in trends both between countries and sectors. In Latvia, investment performance is pleasing, while the drop in exports and weak private consumption slows down the economy. In general, it can be concluded that the Latvian economy is in stagnation, and growth in the coming years does not promise to be rapid either.
A heterogeneous picture in the world
There are significant differences between countries in the world economy, but convergence will unfortunately take place in the direction of weakening. The US economy is doing well, which surprises with its resilience. The middle of the year passed in the sign of growth and a very strong labor market. On the other hand, at the end of this year and the beginning of next year, together with the weakening of consumption, we expect a contraction of the US economy.
On the other hand, the Chinese economy, to which after Covid the end of the pandemic restrictions, which had high hopes, has been deeply disappointed. Consumer sentiment is poor and the housing market sector, which accounts for 30% of China’s GDP, remains in deep crisis. Fiscal and monetary stimulus will continue, but will not be enough to shake the Chinese consumer out of pessimism and a desire to save rather than spend.
The German economy, important to us, in which the manufacturing industry plays an important role, will shrink this year. German industry is suffering from a decline in energy-intensive industries, strong competition in the auto industry from China, as well as a weak China as a key market for manufacturing output. In addition, the German construction industry has also slowed down noticeably. In Germany and Europe as a whole, the service sector, which was relatively strong before, has also begun to slip. The European economy as a whole will be close to stagnation this year and next.
Inflation is falling and interest rates will fall next year
In inflation, the picture is more pleasant – under the influence of the drop in global prices of raw materials and transportation, we see an increasingly significant decline in inflation. For example, deflation was even observed in China in July, while inflation in Europe has already dropped to close to 5%. Due to the weather, the actions of Russia and the decisions of individual countries, the prices of some food raw materials, gas, oil have increased in recent months. However, this relatively small increase follows a very significant period of price decline, which has resulted in prices still well below last year’s levels.
To understand how strongly the internal factors of the economy push prices up, you need to look at the less volatile core inflation. In Europe, core inflation is unfortunately still high (5.5%), and wage growth is also at a historically high level. Although the ECB has already become more lenient in its communication, stubborn core inflation will force it to raise rates by another 0.25pp in September, with the ECB’s overnight deposit rate reaching 4.0%. In April, seeing a retreat in core inflation, a weak economy and possibly a worsening labor market situation, the ECB will begin to ease rates. In 2024 and 2025, rates will decrease relatively rapidly, and the overnight deposit rate will drop to 1.75%. Accordingly, similar dynamics are expected EURIBOR.
The time of high inflation is in the past, but high prices will not go away so easily
Due to the influence of global raw material prices, the price increase in Latvia is also slowing down. The rapid decline in inflation is also visible because the price level was already very high around this time last year – the rate of price increase compared to last year is becoming less impressive every month.
At the end of the year, the price of fuel, as well as the cost of heat energy and gas, will be lower than last year. On the other hand, electricity costs will most likely be higher than those seen last year due to increased distribution and transmission network tariffs. Meanwhile, the situation is different in the sphere of services – here inflation does not recede and prices continue to grow unpleasantly fast. Wage dynamics are essential in service price forecasting. On the other hand, the salary increase this year is predicted to be very rapid – by 11.5%. The minimum wage will increase next year, and the labor shortage will still be high. In 2024 and 2025, salaries will continue to grow by 8% and 7.5%, respectively.
In certain subsequent months of this year, thanks to the drop in energy and food prices, Swedbank a decline in the overall consumer price level is also expected. In 2023, average inflation is forecast at 9.0%, but at the end of the year, inflation will be close to 2%. Also in the first half of next year, the prices of several goods will put downward pressure on inflation, however, the prices of services will maintain an increasing trend. In general, inflation will be 2.0% next year, but in 2025 it will rise to 2.5%.
Stagnation and differences between sectors in Latvia
Minuses crept into Latvia’s economy in the second quarter of the year, but the situation here is not uniform either. Consumption, which was very stable at the end of last year, is visibly slowing down this year – the cost of living and the decrease in purchasing power that has been observed for more than a year is taking its toll. It is positive that since June the purchasing power is starting to recover – Swedbank customer data shows that wages are once again growing faster than prices. However, there is still a long way to go to the previous level of purchasing power. The labor market has been stable – the unemployment rate decreased rapidly at the beginning of the year, remained stable in the 2nd quarter – but recently the data on registered unemployment show a slight increase. We predict that in the second half of 2023 and the beginning of 2024, against the background of the weak economy, the proportion of job seekers could increase slightly. The overall unemployment rate will be 6.5% this year, but will rise to 6.6% in 2024. All this suggests that the development of consumption will remain weak at least in the coming quarters.
We see the already predicted decline in exports. This is due to exports of goods, which are suffering due to the falling construction market and the general weakness of the economies of the partner countries. On the other hand, we still see even double-digit growth rates in the export of services. Here after Covid the pandemic recovery in air transport and tourism, as well as the rise in business services, could continue, but the pace of growth will be slower. Exports of services account for only about a quarter of total exports, which means that they will not be able to offset the projected weakness in exports of goods. A sharper surge in exports is expected only in the middle of next year, when, as interest rates decrease, economic activity in our partner countries will recover.
Positive winds are coming from the investment side, where a faster rise is finally visible. The output in the construction sector grew rapidly in the first half of the year, which is most likely related to the long-awaited inflow of European Union (EU) funds into the economy. The stimulus from EU funds will continue to support investments. However, private investments will recover more significantly only next year, when the ECB starts reducing interest rates.
Recent events in the government do not help the economy. A protracted process of forming the new government would delay the adoption of the budget and add to the already high level of uncertainty. The government crisis may be an additional reason for slower economic development.
The risk of it being worse
The outlook for the economy is already not rosy, but there is a risk that it will be even worse. World economies have still not felt the full impact of the rapid interest rate hike. There are no shortage of weak points. Negative momentum may come from the US banking or commercial property segment. The housing market in many of our partner countries is already in recession, and a further deterioration cannot be ruled out, especially if we start to see a sharper rise in unemployment in the labor market, which has held up well so far.
Under conditions of high inflation, companies were able to pass on the cost increase to the consumer. In addition, turnover and profit indicators in nominal terms have grown rapidly in recent years, while labor costs have increased relatively more slowly against this background, creating a feeling that the company can afford more employees. Currently, demand is weak, but many companies have been able to retain employees due to accumulated reserves from previous years. However, if demand does not recover, selling prices will not be able to increase, but employees, trying to recover the lost level of purchasing power, will demand an increase in wages, companies may have to part with many employees. This could mean a bigger rise in unemployment and a more significant economic downturn than we currently forecast. If we enter a deeper economic recession, then central banks will have to reduce interest rates faster and possibly earlier than we are currently predicting.
On the other hand, if the demand recovers faster, but the labor market holds up better than we forecast, then the big risk is related to the return of inflation. Core inflation is already undesirably high, if global energy or food prices rise due to geopolitical reasons or weather conditions, we can quickly return to very high inflation. In such a situation, central banks will have to keep raising rates and keep them high for a longer period of time. This will mean that the economic crisis will take place a little later, and the fall will start from an even greater height.
The full economic review is available in English here.
The author is Swedbank Latvia chief economist
2023-08-25 04:03:16
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