Central banks focused on rising inflation, including in Latvia.

At the beginning of 2021, prices in Latvia had almost not changed, but during the year they increased and the inflation reached a 10-year maximum (7.9% in December). Analysis of Latvijas Banka demonstrated that growing inflation (3.2% on average per yearAHICP
) was mostly driven by global factors: higher energy prices and other transient supply factors that could become less relevant during the second quarter of 2022. However, geopolitical tensions and the war in Ukraine caused additional risks that will likely keep energy prices high for a sustained period of time.

At the same time, Latvijas Banka warned that tensions in the labour market could result in the pressure of internal factors, i.e. wages, on inflation. These developments should be monitored by Latvian institutions and require an economic policy to prevent labour market overheating, e.g. by balancing the public investment inflows in construction, and by improving labour qualification in the long term.

Chart 1
Decomposition of the Harmonised Index of Consumer Prices (annual changes; %; and percentage point contributions)

State support widely available during the Covid-19 pandemicState support widely available during the Covid-19 pandemicsignificantly mitigated the negative effects on the economy.

In 2021, the GDP grew faster (4.5%) than Latvijas Banka had forecasted at the beginning of the year. The Covid-19 pandemic continued, and the measures restricting the spread of the virus were repeatedly imposed during the year. During the second half of 2021, activity limiting factors such as material and labour shortage, as well as rising costs, in particular energy costs, became more prevalent.

However, as households and companies were able to adjust and the government provided support, the economic activity increased in 2021. The economy recovered to the pre-crisis level as early as in the second quarter of 2021. However, the recovery was not uniform: the sectors more affected by the restrictions and social distancing still have a long way to go.

Chart 2
GDP and value added (at constant prices; 4Q 2019 = 100; seasonally and calendar adjusted data)

Government spending on mitigating Covid-19 effects (2.1 billion euro) was almost 2.2 times higher than in 2020. According to the assessment of the economic impact of Covid-19 related fiscal support instruments conducted by Latvijas Banka, the scope of fiscal stimuli is to be considered reasonable as it helped to reduce the negative difference between the actual and potential economic growthAAccording to calculations of Latvijas Banka, in 2020 the negative output gap was above 3%, while in 2021 it decreased, but still remained negative.
 and contribute to return to full employment and use of other factors of production. Furthermore, Latvijas Banka was an active member of the working groups on development of support measures for individuals and the pandemic mitigation measures at government and expert levels.

Chart 3
Impact of government support on real GDP level (% contribution; cumulatively)

Furlough benefits and wage subsidies limited unemployment growth, and in 2021 the unemployment rate was even lower than in 2020. Most of furloughed employees affected by the pandemic returned to their jobs after the expiry of the benefit periodAAccording to a survey by Latvijas Banka.
 as full-time staff. Support to businesses reduced profitability fluctuations and prevented mass bankruptcies.

During the crisis, the government debt increased, but it made it possible to protect the economy from more sustained negative consequences.

The flexible crisis framework of the European Union fiscal rules made this expansive fiscal policy possible. Moreover, as a euro area member Latvia was able to borrow in international markets for low interest rates. Latvijas Banka supported the government approach: to increase the government debt and budgetary deficit during the crisis to protect the economy from the pandemic shock and avoid long-term negative consequences.

However, Latvijas Banka underlined that during the economic recovery it is necessary to cut the government debt by adjusting it towards sustainability to restore the fiscal space for mitigation of effects of cyclical economic fluctuations in the future.

Structural problems in the labour market hinder economic growth and deepen social exclusion and inequality.

Latvijas Banka concluded that the crisis had disproportionately affected various sectors, professions, regions and societal groups. Although Latvia experienced a strong increase in wages (11.8%), it masked a so-called two-speed labour market.

Sectors more directly affected by the crisis where most people were laid off (such as accommodation and catering) had lower wages even before the crisis. Meanwhile, in some other sectors the number of jobs remained almost the same (e.g. education, healthcare, information technologies), and the wages kept increasing.

Latvijas Banka provided analytical support to improve the social protection system, including for drafting a plan for the improvement of the minimum income support system, assessment of reform options for the pension system, as well as engaged in discussions on improving the taxation, including labour taxation, framework.

The ability of businesses to make profits and increase wages allows improving welfare. Although cost competition indicators deteriorated, in 2021 (as before) the growing external demand continued to be the main factor that led to the growth of manufacturing and goods exports. However, further deterioration of competitiveness indicators may result in significant adjustments. Latvijas Banka noted that the growing lack of workforce, as well as skills mismatch on the labour market was a serious problem that might widen the gap between wage and productivity growth and hinder the ability of companies to compete with producers from other countries successfully. More investment in human capital is a current priority to ensure sustained economic growth in the future.

Chart 4
Latvia's total real exports (annual changes; %; percentage point contributions)

Weak corporate lending and high interest rates hinder economic development and growth in welfare.

To achieve a higher level of welfare, innovation and investments are needed, and it requires active corporate lending. Latvijas Banka under- lined that the conservative lending policy of credit institutions had served as one of the factors that hindered lending, and contributed to a discussion between the financial sector and policy makers on tools to remove obstacles in this area (in December, corporate loans decreased by 4% year-on-yearAExcluding the structural changes and one-off factors in the banking sector.
).

Chart 5
Weighted average interest rates on loans to enterprises (new euro loans; by country; %)

To facilitate continued growth, we should focus not only on mitigating the urgent problems caused by the crisis but also to continue addressing the structural challenges.

Latvijas Banka reminded that long-term growth should be strengthened:

  • to increase productivity, financing from the European Recovery Instrument should be efficiently invested, including in the green transformation and climate objectives, and corporate lending should be encouraged;
  • to improve the availability and quality of labour, investments in the human capital are needed: in particular, in education and health.

Latvijas Banka also focused on sustainability by supporting the inclusion of climate objectives in the ECB monetary policy strategy, by launching its sustainability strategy and offering analysis-based expert opinions in some segments.

Projections of Latvijas Banka's macroeconomic indicators provide information to the public about economic developments, as well as contribute to the discussion on national budgeting and the single monetary policy.

In 2021, Latvijas Banka published macroeconomic projections four times. In June and December, forecasting was carried out within the framework of the Eurosystem forecasting cycle in the Monetary Policy Committee and its Working Group on Forecasting. The Latvian forecasts are part of the euro area common projections serving as a basis for the single monetary policy.

To prepare its forecasts, Latvijas Banka relies both on short-term models for inflation and GDP forecasts, and the DSGE model for medium-term macroeconomic scenarios, as well as expert judgements. At the end of 2021, on makroekonomika.lv Latvijas Banka started publishing bi-monthly model-based flash estimatesAModel-based flash estimates are not official forecasts of Latvijas Banka, and their sole purpose is to provide an insight into the current trends of the key macroeconomic indicators.
 — the Latvian inflation and GDP estimates obtained by relying on the statistical models of Latvijas Banka.