"Although higher interest rates also result in higher borrowing costs for Latvia, the successful work done over the past 10 years, during which the government debt was refinanced for a longer period at record low interest rates, will make it possible to limit a more significant increase in the overall government debt servicing costs. However, it is expected that the indirect effect of rising interest rates – lower demand in export markets – will have a larger impact on the Latvian economy."
"Research contributes to high-quality economic policy decision-making in Latvia and throughout the euro area.
Studies raise awareness of macroeconomic developments in Latvia and allow a more detailed analysis of the economic impact from various shocks."
The reversal of monetary policy to achieve a timely return of inflation to the 2% medium-term target
The year 2022 will be remembered for the unexpectedly high inflation. Part of this increase was foreseen, as price hikes of energy resources were already evident in late 2021 facilitated by the recovery of the global economy. It was already in December 2021 that the Eurosystem staff forecasted higher inflation in the euro area (3.2% in 2022 and 1.8% in 2023 and 2024). However, Russia’s invasion of Ukraine sharply exacerbated the situation in the global energy market. European countries were most affected by reduced Russian natural gas supplies, leading to an almost threefold price increase for natural gas compared to the annual average level of 2021 and sixfold – compared to that of 2015–2021. The forecast of the central banks on the future dynamics of inflation was revised upwards. As the rise in energy prices and the subsequent increase in food prices affected the prices of other goods and services, the world’s major central banks raised their interest rates repeatedly and considerably in 2022 to prevent inflation from taking root. On average, the euro area inflation reached 8.4% in 2022, and according to the December forecasts by Eurosystem staff, prices will rise by 6.3% and 3.4% in 2023 and 2024 respectively, as well as inflation will return close to the target level of 2% in 2025. Latvijas Banka’s experts revised the Latvian inflation forecasts for 2023 upwards as well – from 2.9% a year ago to 10.9% in Latvijas Banka’s December forecasts December forecasts.
The reasons for the current high inflation and its normalisation were discussed at the December 2022 expert discussion “Inflation – then and now”. The discussion concluded that unlike the inflation experienced in 2007–2008, the current problem is global in nature. Being a small, open economy, Latvia “imports” inflation therefore the decrease in inflation will largely depend on the dynamics of global energy and food market prices.
Chart 1. Decomposition of Latvia’s inflation
(annual growth rate; %; contribution; in percentage points)
Inflation in Latvia was significantly higher than in the euro area as a whole. In December, prices in the euro area were 9.2% higher than a year ago, while in Latvia – by 20.7%. The analysis included in the Macroeconomic Developments Report. September 2022 concludes that the difference is partly attributed to a larger share of food and energy in Latvia’s consumption basket and a faster increase in these prices, which is related to administrative regulation, tax changes and a faster transmission of global prices to the local ones. Wages are also growing faster in the Baltic countries, putting an additional pressure on domestic prices.
In 2022, the high inflation was mainly caused by the supply side, i.e. it was driven by higher commodity prices. However, the effects of the supply shock can become more persistent in the event of transmission to other goods and services. The analysis by experts of Latvijas Banka concludes that inflation is also increasing in the product groups included in the core inflation calculation. If the process continues, consumer inflation expectations may change and employee requests for salary increase may follow an upward trend, thus triggering persistently high inflation. Therefore, in order to prevent inflation from taking root, the ECB has raised its interest rates.
Chart 2. Latvia’s inflation components by growth rate
(% of total)
To contain the soaring inflation and the rise in inflation expectations, the ECB initially needed to raise interest rates at faster pace so that they also rise in real terms. Later, as interest rates approached the natural or neutral level, step down in the pace of interest rate increases followed in December 2022; however monetary policy still moved in the direction of tightening financial conditions. Articles explaining what the natural interest rate is and what interest rates can be expected in the future have been published on the economic analysis website of Latvijas Banka www.macroeconomics.lv.
A study conducted by Latvijas Banka looks at the effectiveness of non-standard monetary policy instruments (for example, asset purchases) under different macroeconomic conditions and concludes that they do not fully substitute conventional interest rate policy. Thus, currently higher interest rates remain the main monetary policy tool for driving down the inflation.
What higher interest rates entail for the Latvian economy was discussed at the expert discussion “Rising interest rates – bitter medicine to prevent infection” interest rates – bitter medicine to prevent infection” in October. Experts of Latvijas Banka together with experts from credit institutions and the Treasury, as well as representatives of business organisations, concluded that higher interest rates could pose a series of challenges to certain companies and households with a higher debt burden. Although the direct impact on the Latvian economy as a whole will be mild, restrictive monetary policy will materialise, to a large extent, through economic developments in the euro area and lower imported inflation. The direct impact of the increase in interest rates is somewhat confined by a low level of borrowing for both households and businesses. Although higher interest rates also result in higher borrowing costs for Latvia’s government, the successful work done over the past 10 years, during which the government debt was refinanced at longer maturities and at record low interest rates, will limit the increase in the debt servicing costs. However, it is expected that the indirect effect of rising interest rates – mainly lower demand in export markets – will have a non-neglibible impact on the Latvian economy. As liabilities of households and businesses to credit institutions in the European Union are almost three times higher than in Latvia, rising in interest rates will affect the economies of these countries more severely. This will also be reflected in lower demand for products of our companies.
The use of other monetary policy instruments in the ECB’s toolkit was also revised when commencing a rise in interest rates. First of all, following the end of net asset purchases under the asset purchase programme (APP) in July, the securities portfolio held by Latvijas Banka for monetary policy purposes no longer continues to grow rapidly. Second, according to the December 2022 decision taken by the Governing Council of the ECB, the APP portfolio will be reduced by an average of 15 billion euro per month as of March 2023. In compliance with the capital key, the portfolio of Latvijas Banka could decrease by almost 50 million euro per month.
Expert discussion “Inflation then and now”
Chart 3. Outstanding value of securities held for monetary policy purposes by year according to their maturity
(billions of euro)
Third, as the favourable conditions of targeted longer-term refinancing operations (TLTRO) were scaled back, Latvian credit institutions also accelerated the repayment of funds borrowed from Latvijas Banka. The reversal of these non-standard instruments is necessary in order to restore policy space to manage potential future crises successfully.
The increased ECB interest rates have also resulted in higher euro area government bond yields.
Chart 4. The ECB’s interest rate on the deposit facility, 3-month EURIBOR, the yield on 10-year Latvian government bonds and the interest rate on new loans to Latvian businesses
(monthly average; %)
New debt issuance has become more expensive for the government of Latvia. According to the European Commission’s guidelines, 2023 will be a transitional year for fiscal policy, as the deactivation of the general escape clause and a return to a neutral fiscal stance (as opposed to the supportive fiscal stance that was characteristic of the Covid-19 pandemic period) is scheduled for 2024. If the governments of the euro area countries fail to normalise fiscal policy and try to continue the expansionary approach, monetary policy may have to react much more firmly than expected by the financial markets, raising interest rates even further. Such a combination of policy instruments (supportive/still expansionary fiscal policy and restrictive monetary policy) is not desirable as it will slow down the return of inflation to the 2% target in the medium term.
Consulting the government on providing fiscal support – in order to mitigate the negative impact of the energy price crisis and slowing economic growth
In 2022, the government provided support to the population and businesses totalling 2.2% of gross domestic product, mitigating the impact of the rapid increase in energy prices and high inflation. Latvijas Banka used various large-scale macroeconomic models to assess the impact of these measures on output, inflation, and disposable income for different population groups. Estimates suggest that the fiscal response was proportionate and that it helped to reduce the depth of the recession and slow down the rise of inflation (see Government support during the energy crisis. Impact on the economy). These support measures are certainly necessary in the energy price crisis, and they stabilise the economy in the short term; however, public investment is crucial for strengthening the potential of economic growth in the long run to enhance energy efficiency and energy independence.
Chart 5. Impact of government support on inflation
(in percentage points; year-on-year)
Latvijas Banka has compiled best practices, experiences and recommendations of European countries regarding the support measures applied during the energy price crisis, also providing advice to the government and various working groups. Meanwhile, government support measures used in the heating season of 2022/2023, compared to the beginning of the year, have become more targeted, while maintaining the incentives to reduce consumption, which accordingly increases the efficiency of the support, mitigating its fiscal impact.
As regards matters of tax policy, the discussion on a possible cut of the labour tax wedge became topical at the end of 2022. The labour tax wedge in Latvia (as in most European Union countries) is relatively high, so an argument can be made in favour of reducing it; however, in order to reap the maximum economic benefits of such a step, it should be implemented under conditions where labour market reserves are abundant and inflation has slowed down (see the article for more details). Considering Latvia’s low ratio of tax revenues to the size of the economy compared to other countries of the region, the labour tax cuts, if implemented, should be carried out in a fiscally neutral way.
Chart 6. Tax burden by employee remuneration group (November 2022)
(tax burden; %; gross wage; euro)
As of 1 January 2023, the national minimum wage has been increased from 500 to 620 euro. Such a move will help to mitigate the poverty risk and inequality among employees, but it also has side effects. A higher minimum wage can reduce employment, particularly among younger and low-paid employees. Namely, if employee productivity is below the minimum wage level, the employer has no economic justification for retaining the job (position). The impact of a higher minimum wage can vary quite widely across sectors – for more details, see Macroeconomic Developments Report. September 2022.
In times of crises, when the private sector adopts a wait-and-see attitude due to high uncertainty, public investment can serve as an important factor stabilising the economy. However, in 2022, the total public procurement in the construction sector, including projects financed by EU funds, was lower and slower than expected when planning the budget. As a result of Russia’s invasion of Ukraine, the traditional suppliers were lost, and the prices of building materials and energy hiked. The extension of deadlines and revision of contract prices or even termination of contracts hindered the implementation of public investment.
Latvijas Banka’s research shows that in OECD countries, including Latvia, each euro invested in the public capital attracts private investments worth two euro on average. Thus, returning to a more balanced fiscal policy should not come at the expense of public investment. Public investment is a good way to strengthen the private sector’s investment activity and make a significant contribution to economic growth.
Experts of Latvijas Banka model the extent of construction project price increases and possible shifts in implementation schedules (including Rail Baltica), and also identify and estimate total public investment plans for the coming years to assess the adaptability and risks of the construction sector. In 2022, several discussions took place (including with representatives of the OECD, the Ministry of Economics and the Ministry of Finance), and experts of Latvijas Banka pointed to the need for drawing up and publishing public investment plans for the medium term in a centralised manner, including information provided by municipalities and other budget institutions. This would help to balance public procurements over the time scale, thereby reducing the risk of further price hikes, and would also foster the private sector’s capacity building in planning and completion of works, quality and predictability in the sector as a whole.
Improving analytics – for assessing the potential of sustainable economic development
Research enhances the adoption of deliberate economic policy decisions in Latvia and the euro area. Working papers published in 2022 analyse topics crucial for the Latvian economy: Survival of Latvian companies and their products in export markets, companies and their products in export markets, the frequency and extent of price changes in euro area countries, area countries, and the assessment of the size of shadow economy. These working papers deepen understanding of macroeconomic developments in Latvia and allow a more detailed analysis of the economic impact from various shocks. In 2022, the results of research conducted by Latvijas Banka were presented at 34 international scientific conferences or research seminars, they were reflected in 6 working papers of Latvijas Banka, 2 discussion papers and 3 articles published in scientific journals (see Annex 5).
Development of “green economy” models also continued. These models will help to understand the various channels through which climate risks and countries’ response to them will affect the Latvian economy (see an example of the models here).
Experts of Latvijas Banka have analysed the current energy efficiency of buildings in Latvia, estimating the potential of saving heat energy in buildings, as well as explaining the reasons which have led to the current situation and offering solutions for increasing the pace of building renovation. Experts of Latvijas Banka have pointed to the main steps to be taken to implement the transformation of the Latvian energy industry and the entire energy supply system much more successfully when dealing with the crisis of energy availability and prices.
The discussion on sustainable economic policy and energy literacy was brought to the fore, as both the pandemic and the energy price crisis, which required immediate solutions, highlighted a backlog of work to be accomplished in the field of sustainable development. Urgent solutions concerning the necessary support measures have further exposed Latvia’s budget expenditure to climate risks. Such situations can also contribute to hyped demand, price hikes, as well as the risk of incompletely coordinated solutions.
Gross domestic product and income describe the population’s material wealth, but they are only tools for improving people’s quality of life. Latvijas Banka analysed how residents of Riga rate their quality of life, taking into account various aspects, such as safety, environmental pollution, demography, housing availability, etc. Comparative measurements of the quality of life show that Riga is far behind Tallinn, Vilnius and most European cities in this regard in comparison with income of the population. The results of the analysis were presented to Riga municipality officials. A discussion paper was also published on this topic and an expert discussion “How can Riga cope with the Baltic competition and regain the status of a European metropolis?” was held. The study concluded that the quality of life in the capital can be considerably higher even without any changes in the current level of income (gross domestic product per capita) and the number of population. This shows that Riga has a substantial development potential.
