The Eurosystem maintained a tighter monetary policy in 2023, though the inflationary pressures attributed to external factors continued to ease, as projected at the end of 2022.
At the same time however, the upward pressure on inflation from internal factors including wages grew stronger.
Latvia's economic downturn in 2023 was milder than had previously been projected, but the pace of further economic development remained highly uncertain. The high level of uncertainty also affected the direction of monetary policy, because tightening the monetary policy stance too rapidly could increase the risks of the economy cooling faster and falling into recession, while a monetary policy that was insufficiently restrictive would add to the risk that inflation might not fall far enough to reach the ECB target, contributing additionally to the risk of a further wave of inflation. To prevent this happening, an even tighter monetary policy would be needed, and that could have an adverse effect on long-term economic growth.
Chart 1. Changes in real wages
(compensation per employee; %; annual change)
The robustness of the labour market and the ability of employees to leverage it when negotiating with employers combined with the support from the government to offset gradually the decline in purchasing power caused by the Covid-19 pandemic and the surge in energy prices. This allowed companies to keep making relatively high profits and kept inflation from falling even more sharply.
Chart 2. Annual changes in the GDP deflator by component, Latvia
(%; percentage points)
Chart 3. Annual changes in the GDP deflator by component, euro area
(%; percentage points)
Latvia's economic downturn in 2023 was milder than had previously been projected, but the pace of further economic development remained highly uncertain. The high level of uncertainty also affected the direction of monetary policy, because tightening the monetary policy stance too rapidly could increase the risks of the economy cooling faster and falling into recession, while a monetary policy that was insufficiently restrictive would add to the risk that inflation might not fall far enough to reach the ECB target, contributing additionally to the risk of a further wave of inflation. To prevent this happening, an even tighter monetary policy would be needed, and that could have an adverse effect on long-term economic growth.
Given the high degree of uncertainty and the dilemma of the monetary policy stance being either overly tight or insufficiently tight, the ECB dropped its forward guidance about the desired future level of interest rates on 16 March 2023 and underlined the importance of a data-based approach to the decisions taken by the Governing Council on policy rates.
Three key elements that affected the monetary policy decisions taken by the ECB in 2023 were:
- the assessment of the inflation outlook;
- the dynamics of core inflation;
- the strength of monetary policy transmissions.
The rise in interest rates was also significant as a means to reach the inflation target and keep inflation expectations anchored while the labour market was stronger than anticipated and actual inflation in the first half of the year was surpassing forecasts. The rise also exceeded the expectations of market participants, who had forecast maximum interest rates of around 3% at the start of the year.
Interest rates have, however, stopped rising since September 2023. Reasons for this are the previously steep increase in interest rates, the effectiveness of earlier monetary policy decisions in significantly reducing inflation and helping it converge to the ECB target in the medium term, and the high level of uncertainty about how strongly the current tighter monetary policy will be transmitted over time.
At the end of 2023, financial market participants were no longer expecting any further rises in the interest rates set by the Governing Council of the ECB. Instead, the discussion primarily focused on how long those rates would need to remain at their current level to help reach the ECB target.
Chart 4. ECB interest rates and money market rates (%)
Latvijas Banka's estimates suggest that higher interest rates have played an important role in reducing price pressures both in Latvia and in the euro area. Inflation in Latvia would have been at least two percentage points higher in 2023 if the Eurosystem had not reacted to the rapid rise in inflation. Interest rate rises mostly reduce price pressures in Latvia through the exchange rate channel, as a more valuable euro helps moderate the price pressures from imported goods, including energy.
Chart 5. Inflation and core inflation in Latvia and the euro area
(%; annual change)
At the same time, the changing conditions that required monetary policy to be tightened also allowed the normalisation of the balance sheet of central banks to be started and the ongoing asset purchase programmes to be discontinued. The Eurosystem first acted using the policy instrument of interest rates, and only then decided to decrease the outstanding securities purchased under the asset purchase programme (APP) and the pandemic emergency purchase programme (PEPP) because interest rates were affecting financial conditions, aggregate demand and so also inflation in a more direct and faster way. The outstanding amount of securities purchased previously was reduced at a measured and predictable pace. The Eurosystem initially stopped reinvesting in full the principal payments from maturing securities, then later on ceased investing principal payments entirely. This gradual approach was necessary so that the response of the financial market could be monitored, particularly so that its capacity to absorb the new issues of securities without causing fragmentation in the securities market could be assessed.
Chart 6. Balances of the Eurosystem's monetary operations
(trillions of euro)
Chart 7. Including the balances of Latvijas Banka's monetary operations
(billions of euro)
The income of credit institutions fell as the balance of the targeted longer-term refinancing operations declined and the remuneration for minimum reserves fell, but there remained a large amount of excess liquidity in the credit institution system in Latvia even so. Meanwhile, Latvia's credit institutions saw their profits soar as the interest rates on loans surged rapidly while the expenses on deposits grew significantly more slowly, and this alleviated concerns about the financial system being weakened by the sharp rises in interest rates.
Chart 8. Banks' return on equity in Latvia and the euro area (%)
In the focus of macroeconomic analysis – the response of Latvia's economy to the changes
Latvia's economy was affected significantly in 2023 by various external factors:
- the consequences of rising energy prices;
- weak external demand, particularly in construction-related sectors, which impacted exports of wood products, the most important export commodity from Latvia;
- changes in trade with Russia, notably the weakening of economic ties following its full-scale invasion of Ukraine and the ensuing sanctions.
Risks to the competitiveness of exports and to economic growth come from the steady, steep climb in wages in Latvia, particularly as weak external demand intensified competition among companies vying for customers. Costs in Latvia are rising relatively faster than those in trading partners, but they remain lower in several segments than those of competitors, and export market shares may expand as foreign consumers favour Latvian products.
Chart 9. Real effective exchange rate and the share of exports of goods and services in global imports
(2015 = 100)
Discussions in the forum of experts at the beginning of this year considered the economic repercussions for Latvia of Russia's full-scale invasion of Ukraine. It might be expected that the war, sanctions and ethical considerations would make companies less willing to trade with aggressor countries, but the statistics do not reflect this. Trade with Russia and Belarus persisted despite Russia's full-scale invasion of Ukraine. A fall on the imports side was only felt in early 2023, while the exports side proved much more resilient. At the same time there was a leap in exports to the countries of the Commonwealth of Independent States. The surge in energy prices that led to higher bills for heating, electricity and other utilities dealt a painful blow to Latvia's economy, causing headaches for almost every household and company.
Latvijas Banka's analysis of trade in goods under sanctions with Russia, Belarus, the Commonwealth of Independent States and other countries with close ties with Russia was used to inform the institutions responsible about the possible circumvention of sanctions, and decisions were taken to strengthen the sanctions.
The next significant drivers of economic trends in Latvia were rising interest rates and the changes in credit conditions and lending volumes that resulted from the tight monetary policy of the Eurosystem.
Higher interest rates affect Latvia's economy through several channels:
- household budgets. Since household loan payments in Latvia are mostly linked to the short- term EURIBOR, higher interest rates mean larger monthly loan payments, which put pressure on households to reduce their spending on other categories of goods and services;
- higher costs for bank credit and investment. The rise in interest rates makes potential investment projects more expensive, reducing new investment activity;
- government debt servicing costs. Higher interest rates mean borrowing is more expensive for the government and interest expenses are higher in its budget;
- postponement of consumption. The increase in interest rates motivates a part of the population to postpone consumption in favour of savings that earn interest. This reduces private consumption;
- foreign demand. The rise in interest rates also affects Latvia's trade partners, squeezing their economic activity and thus also demand for Latvia's exports.
Latvijas Banka's calculations using the DSGE model for Latvia that the most important of these channels are the weakening of economic activity in Latvia's trade partners and the consequent contraction of foreign demand, and the postponement of new investments and government spending because borrowing costs are higher.
A specific focus was turned on the bank credit channel because even though money market interest rates rose evenly in all the euro area countries, the further transmission from the money market interest rates to the interest rates on loans and the dynamics of loans in the euro area varied significantly. Latvia was among the countries with the sharpest climbs in interest rates and the steepest drops in lending.
Chart 10. Interest rates on new euro-denominated loans to companies and to households for house purchase in the euro area
(%; 3-month average)
Chart 11. Outstanding loans to companies and households in the euro area
(% of GDP)
To help transmit the rise in the financial market interest rates to the depositors in credit institutions, Latvijas Banka began to compile and publish a regular review of the deposit rates offered by credit institutions. This is one of the measures that gave the public more comprehensive information about the services offered by credit institutions, which facilitated competition by helping clients in choosing a service provider offering more advantageous rates.
Chart 12. 12-month deposit rates offered by banks and 12-month EURIBOR (%)
Comparisons between the Baltic States reveal that the lack of investment correlates with lower levels of welfare in Latvia. There are a variety of reasons why investments are more subdued in Latvia, some on the supply side like bureaucratic obstacles and formalities, corruption, and the shadow economy, and some on the demand side like the weak purchasing power of the population and the low productivity of businesses, or the lack of links between science and the commercial sector. These factors are compounded by the limited availability of funding.
The factors that have limited access to financing in Latvia over the past 10–15 years were detailed in the report Financing of the Economy 2023 published by Latvijas Banka. The report concluded that the decline in lending activity in the corporate segment came more from access to financing being limited than from companies being unwilling or unable to borrow. That the decrease in lending activity has been observed simultaneously with an improvement in the financial situation of companies points to the availability of loans having deteriorated.
Chart 13. Reasons for dissatisfaction with external financing
(% of companies that used external financing; 2018–2022)
The financial situation of households and their creditworthiness have also notably improved, but this has not been reflected in a significant expansion of lending for housing. The reasons for this lie in several structural flaws, such as bureaucratic obstacles to the construction process and the relatively high lending rates and limited availability of loans in the regions outside the capital area.
In October 2023, Latvijas Banka held an expert discussion panel on the topic "How do we address persistent problems in financing the economy?", highlighting the challenges Latvian businesses face when raising external financing. It was concluded that no quick and simple solution was feasible, and that the greatest long-term benefits would stem from competition between the banks strengthening and from other sources of external financing.
To strengthen competition between the banks, Latvijas Banka worked with other institutions to draft proposals that simplified the refinancing of housing loans. These proposals aimed to ease the restrictions on advertising and significantly reduce the costs of refinancing loans by prohibiting fees for customers leaving their current bank, abolishing Land Register duties, and limiting other costs. These changes will bring several benefits to Latvia's population:
- obstacles to active customer poaching by banks and other lenders will be removed, allowing them to offer customers more favourable terms and conditions, and more attractive services;
- loan refinancing costs will be considerably lower;
- the number of people reaping financial benefits from refinancing their loans will increase notably.
Latvijas Banka's estimates Latvijas Banka's estimates suggest that about half of all borrowers would be financially motivated to refinance their housing loans under the new regulation.
Finally, Latvijas Banka extended its analytical focus in 2023 to encompass matters relevant to the sustainability of Latvia's economy, including an examination of the impact of the tax system. Latvijas Banka's calculations from various economic models and the results of the analysis suggest that the effect of changes in the labour tax burden is not homogeneous. There are several options for changing the labour tax burden, and each of them will have a different macroeconomic impact and a different impact on the income of various social groups. Latvijas Banka used these and other calculations to produce its opinion for the tax working group organised by the Ministry of Finance.
Latvijas Banka's annual international economic conference "A Recipe for Economic Growth"
Matters related to long-term growth were also discussed at Latvijas Banka's annual conference, which brought together internationally recognised experts to discuss the reasons behind the slowdown in global economic growth that has been observed over recent decades. The main conclusion was that there is no single recipe that can guide us towards swift and resilient economic growth. Instead, we should observe various principles for preventing the most frequent mistakes from hampering the potential for growth, including:
- ensuring a favourable environment and opportunities for all businesses rather than selectively favouring a few under the misleading guise of industrial policy;
- introducing changes to refine current strategies and bolster development rather than constantly crafting various new visions and strategies;
- prioritising long-term goals even when there are no immediate.
Research: helping to make decisions based on analysis
The year 2023 proved to be a productive one for research at Latvijas Banka. Researchers from the bank delved into key issues concerning monetary policy, fiscal policy, sustainability, inflation, the labour market, and more. The results of the research have deepened insights into topics that are highly relevant for Latvia and the euro area as a whole, and have also contributed to discussions around economic policy.
- In 2023, Latvijas Banka published 10 scientific articles in the form of nine working papers and one discussion paper, which was the largest number of publications within a calendar year ever.
- Latvijas Banka's employees published six articles in international scientific journals.
- Latvijas Banka's employees presented their research at 50 academic conferences and seminars.
- Eleven research seminars were held, and were attended by internationally renowned economists.
- The results of Latvijas Banka's research were presented at seminars hosted by the EC, the EIB and the IMF.
- The conference held by Latvijas Banka and the Baltic Economic Association was a resounding success.
- Several research projects were successfully launched in collaboration with international researchers.
Working papers on the latest developments in monetary policy such as quantitative tightening and the portfolio rebalancing of quantitative easing offered insights into the macroeconomic impact of the instruments on the central bank's balance sheet.
Two working papers were produced on fiscal policy that explored the effect of inflation on fiscal indicators, and the sustainability of budgetary policy. The working paper co-authored with researchers from Eesti Pank concluded that an increase of one percentage point in the inflation rate led to an improvement of around 0.7 percentage point in the primary balance. Inflation improves the primary balance both by increasing the ratio of budget revenues to GDP and by decreasing the ratio of expenditures to GDP. The working paper co-authored with researchers from the University of Lisbon also arrived at similar conclusions. Its results suggest that higher inflation rates may be used to improve fiscal sustainability.
A working paper on the effect of job retention schemes on employment in Latvia was also released. It compared similar firms that received or did not receive support from the job retention scheme. Firms that benefited from the job retention scheme displayed significantly greater resilience in employment than similar firms that did not receive such support. Moreover, the benefits of this support extended beyond its initial receipt, positively impacting firms for several months afterwards.
Improvement of the modelling toolkit for the green transition also continued in 2023. The Computable General Equilibrium model was improved by incorporating a detailed emissions block and developing a new approach to modelling the energy sector and the mutual substitution of the energy or energy products used. This model paves the way for a sector-wide exploration of the economic impacts of changes in the energy sector and of firms switching to cleaner energy sources.
Similarly, the dynamic general equilibrium model with two physical capital types, one brown and one green, and input-output sectoral linkages was developed to examine the economic impact of capital stranding. The working paper illustrates the effect of various policy instruments, including a carbon tax, on the productive capacity of capital and on aggregate economic activity.