Monetary policy: inflation is approaching its target, interest rates are falling
In 2024, inflation in the euro area continued to move towards the ECB's medium-term target of 2%. Inflation in Latvia was low, with prices rising by 1.3% over the year. Compared to previous years, the slower price growth in the euro area and Latvia was partly affected by the reduction of previous external shocks (increase in oil and food prices); nevertheless, core inflation also continued to move towards its target.
Chart 1. Headline and core inflation in the euro area and Latvia (%)
Source: Eurostat.
The ECB's past monetary policy tightening played an important role. With inflation declining significantly and approaching the 2% medium-term target, the Governing Council of the ECB stopped raising interest rates in 2024 and started to gradually ease them in the middle of the year, yet monetary policy remained restrictive. This helped keep inflation expectations firmly anchored to the 2% target and prevented price fluctuations, caused by temporary and transitory factors, from turning into lasting and sustained price increases.
As concluded in Latvijas Banka's working paper, the interest rate increases implemented in 2022 and 2023 had a significantly stronger impact on inflation than in previous monetary policy tightening cycles in the euro area. Importantly, the convergence of inflation towards the central bank target was achieved without an excessive slowdown in economic growth. As a result, the sacrifice ratio was at a historically low (most favourable) level.
Chart 2. Sacrifice ratio of monetary policy
Source: Latvijas Banka's calculations.
Note. The chart shows the sacrifice ratio. It is calculated by dividing the maximum response of real GDP to a traditional monetary policy shock by its maximum impact on inflation derived from impulse response functions, using structural vector autoregression with time-varying parameters and stochastic volatility.
While central banks managed to prevent economic recessions in euro area countries and the overall labour market remained strong, economic growth in the euro area was weak. The outlooks for economic growth and the medium-term were revised downwards on several occasions during the year. This was driven both by external factors (escalation of geopolitical conflicts, trade tensions, and rising protectionism) and by the still high uncertainty surrounding the future economic course in the US and elsewhere. The sluggish economic activity in the euro area is also explained by a fragile recovery of domestic demand, with high consumer caution and a tendency to accumulate savings. Industry experienced a downturn due to both cyclical and structural factors, thus highlighting the problem of structurally weak competitiveness in the euro area. The strategic document "On the Future of European Competitiveness" prepared for the EC by Mario Draghi and published in autumn sets out the necessary steps at the EU and national level in three areas – innovation, decarbonisation, and competitiveness, as well as reducing security and resource dependencies – to restore resilient and sustainable growth in the region.
In response to the high level of uncertainty, the change in the ECB's monetary policy (interest rate cuts) was implemented gradually and continued to be based on pre-established principles, taking into account:
- the Governing Council's updated assessment of the inflation outlook;
- the dynamics of underlying inflation, excluding more volatile prices;
- the strength of monetary policy transmission, avoiding forward guidance. As a result, financial market participants paid great attention to data and interest rates were volatile at times, but overall market expectations are in line with inflation moving towards the 2% target during 2025.
Chart 3. Deposit facility rate and its future expectations; 3-month and 6-month EURIBOR
Sources: Bloomberg, Latvijas Banka's calculations.
Note. The spread between the ECB's deposit facility rate and the €STR is assumed to remain at the average level of 2024.
Overall, since the change of monetary policy, the main challenge for the ECB and the euro area national central banks has been to find the right balance between developments in the real economy, the financial sector, and inflation:
- An overly rapid slowdown in economic activity may also have a negative impact on medium-term inflation, so the aim of reducing interest rates is to support economic growth by avoiding protracted periods of low growth. At the same time, growth is held back by structural problems in the euro area and may also be affected by supply shocks, which complicate the work of monetary policymakers.
- The decline in inflation was uneven across all components. Overall, inflation fell rather rapidly since reaching its peak in autumn 2022; however, the inflation component of domestic demand – services inflation – remained resilient, mainly owing to strong wage growth. This created uncertainty as to how quickly headline inflation would return to the 2% target and thus warranted caution also in terms of interest rate cuts.
- A successful and effective monetary policy depends on the stability of the financial sector, as it facilitates the transmission of monetary policy changes to the real economy. Excessively long implementation of an overly tight policy may weaken the financial sector and make it less responsive to policy changes, which has led to an increased focus on the functioning of the financial sector. Despite the steep increase in interest rates in 2022–2023, the ratio of non-performing loans in bank loan portfolios increased marginally in most cases, while profitability improved significantly. This points to the ability of banks to provide credit to the economy and support its growth.
Chart 4. Non-performing loans in Latvia and the largest banks in the EU on average (%)
Source: EBA.
The Latvian economy: interest rate declines (an enabling factor) vs external developments and structural changes (a limiting factor)
In addition to the reversal of monetary policy, the Latvian economy continued to be affected by the still unfavourable developments in the external environment. Uncertainty related to the escalation of global geopolitical tensions and persistent warfare in Ukraine remained high. External demand was weak in a number of important trading partners, including a decline in construction activity in the Scandinavian countries. As a result, the Latvian economy stagnated. Latvijas Banka's macroeconomic analysis covered both internal and external factors in order to understand to what extent weak growth was driven by cyclical or structural factors, and to be able to offer appropriate policy recommendations to policymakers.
Growth forecasts of European countries and other main export partners of Latvia were significantly lowered in the course of 2024. Estonia and Germany experienced a recession which significantly hampered export growth. However, the persistently rapid increase in labour costs, far ahead of productivity, has also started to adversely affect the competitiveness of exporters.
Chart 5. Unit labour costs in manufacturing in the Baltic States
(index, 2019 = 100)
Source: Eurostat.
Income growth and low inflation created favourable conditions for consumption, and the decline in interest rates supported lending activity in Latvia. However, similarly to the external sector, domestic demand was dampened by the geopolitical situation and the persistently tight credit supply in the banking sector. This included the low risk appetite of the financial sector, as evidenced by the high share of financially constrained companies and high collateral requirements on the part of lenders (see the report Financing of the Economy 2024 for more details).
Lending activity in Latvia remained subdued and interest rates were among the highest in the euro area countries. At the same time, housing loan segment showed some positive developments, of which the most notable is the decline in lending rate markups. For instance, in 2018, households willing to receive a loan for house purchase or construction were subject to a markup of about 2.4%, but in late 2024, the average markup stood at 1.5%.
Chart 6. Markups of new mortgages by volume (%)
Source: Credit Register of Latvijas Banka.
Note. Including loans with a reduced rate or a 0% markup applied on a temporary basis. At the time of issuing such loans, there is no information about the markup to be applied following the discount period.
Meanwhile, the corporate lending segment showed little sign of positive change. Lending rates remained high, driven by substantial markups and a predominance of variable interest rate loans. This concern was echoed during an expert discussion, where it was highlighted that even successful Latvian companies – particularly those oriented toward exports and performing well in international markets – face severe challenges in obtaining the necessary financing from the Latvian banking sector.
To improve the lending conditions, competition in corporate lending must also be intensified, with one option being a reduction in loan refinancing costs, which currently pose a significant obstacle to firm mobility between banks. For companies, loan refinancing costs include not only the fee for the new loan agreement (around 1% of the loan amount), but also a fee for early repayment (around 1.5–2% of the outstanding loan amount). These costs constitute a substantial financial burden, discouraging firms from seeking more favourable terms from competing lenders. To address this issue, Latvijas Banka has put forward legislative proposals aimed at lowering these barriers and promoting a more competitive lending environment.
The challenges faced by Latvia are not unique – similar patterns are evident in the corporate lending markets of Lithuania and Estonia. These regional dynamics were a focal point of the 2024 Economic Conference Financing a Better Future. The Vital Role of Finance in Achieving Sustainable Growth, which explored pathways toward a more robust and competitive financial system. The conference concluded that much remains to be done to move towards a single EU banking sector and capital market that would provide European companies with wider and more attractive access to financing. However, while this progress is slow, solutions to improve the availability of financing can also be found at the national level. One example of this is Latvia. At the beginning of 2024, on the initiative of Latvijas Banka, legislative amendments were made to remove barriers to the mobility of mortgage borrowers and thus promote competition in the lending market.
Latvijas Banka's Economic Conference Financing a Better Future. The Vital Role of Finance in Achieving Sustainable Growth, 2 October 2024.
However, the weak growth of the Latvian economy in recent years cannot be fully explained by the high interest rates and the low risk appetite of the banking sector. Similarly to the euro area as a whole, faster economic growth in Latvia is hampered by a number of structural problems and challenges that require unique solutions. Otherwise, even with the best financial conditions, the Latvian economy will continue to stagnate in the long term.
This was the focus of the expert discussion How to achieve SUSTAINED growth in the Latvian economy? Latvia's economy can certainly grow faster than the typical 2–3% per year. Overall, the income level in the economy is determined by the interaction of three factors: how successfully we use labour resources, how much we invest in development, and how wisely we are able to use the available labour force and capital. In each of the areas, work should be carried out to promote stable economic growth, increasing the wealth of the country and its people.
Chart 7. European Union Regional Competitiveness Index RCI (EU average = 100)
Source: EC.
For example, strengthening human capital – in particular by reducing early working-age mortality, activating internal labour reserves, promoting the quality of education and the health of the population, as well as attracting highly qualified workers from abroad – can significantly increase the growth rate of the economy. Greater investment and innovation would also make a major contribution to economic growth.
Latvijas Banka has also assessed the economic impact of the recent tax reform implemented by the government. The findings indicate a positive short-term effect, primarily driven by increased private consumption stemming from higher net wages. However, the reform is not expected to deliver lasting structural improvements and is unlikely to enhance the long-term competitiveness of the Latvian economy.
The reduction of contributions to the second pension pillar represents a particularly adverse development. In 2024, a decision was made to reduce the tax burden on labour, partly financed by reallocating contributions from the second pillar to the first. As of 2025, these contributions are adjusted to 15% and 5% respectively. Consequently, instead of strengthening the pension system and improving pension substitutability in the future, these legislative changes are heading in the opposite direction. By shifting contributions to the first pillar, the state also assumes increased long-term pension liabilities, which will raise future pension-related expenditures from the public budget. Moreover, these changes set an unfavourable precedent that risks undermining public confidence in the Latvian pension system.
Research
Research is an essential tool for Latvijas Banka's economic analysis, helping formulate evidence-based monetary policy, while also contributing to structural and fiscal policies.
In 2024, eight working papers were published in Latvijas Banka's scientific outlets. Additionally, Latvijas Banka's researchers were among the authors of the working papers published in three ECB publications. The results of these and other working papers were presented at international scientific conferences and academic seminars, including in Suomen Pankki, Banca d'Italia, and Deutsche Bundesbank. The quality of the working papers authored by Latvijas Banka's researchers is also confirmed by six publications in high-profile international scientific journals, such as American Economic Journal: Macroeconomics.
The working papers improve our understanding of economic developments and identify the necessary policy interventions. For example, the working papers related to monetary policy helped explain the reasons for high inflation in the Baltic States, as well as understand how the desired monetary policy response changes in the light of uncertainty regarding the mechanism of inflation expectations formation.
In the area of fiscal policy, Latvijas Banka's researchers, in cooperation with researchers from the University of Lisbon, drew attention to the risks associated with the high level of government debt in developed countries. The working paper concluded that rising debt levels have not been reflected in higher insolvency risks, as the average maturity of public debt has also increased significantly. While governments currently – with longer public debt maturities – have more freedom to borrow without negative consequences, higher interest rates are set to increase debt servicing costs eventually.
Researchers of Latvijas Banka also continued to analyse the effectiveness of various crisis support measures. An analysis of the effect of job retention schemes on employment concluded that employees benefiting from the job retention scheme were statistically significantly more likely to remain in their current job than equivalent employees who did not receive such support. At the same time, the relatively low benefit ceiling reduced the attractiveness of benefits for higher-skilled and better-paid workers and thus motivated companies to redirect support to lower-skilled workers. This in turn led to a deterioration in the skills profile of employees in companies that benefited from the job retention scheme. These lessons should be taken into account when using similar support measures in the future.
Other working papers covered topics related to sustainable economic growth. Latvijas Banka continued to improve its modelling toolkit for analysing the economic impact of the green transition, as well as to analyse various issues related to social sustainability. One working paper focused on inequality of opportunities or how childhood living conditions influence income levels in adulthood. The results suggest that a significant share of income inequality (around 11%) is due to unequal living conditions during childhood.