Monetary policy: a "good place" reached, but not set in stone. Future interest rate moves will depend on incoming data.

Global economic growth continued to be affected in 2025 by geopolitical instability and high uncertainty, amplified in the first half of the year by the increase in import tariffs envisaged by the US Administration and the related shocks to global supply chains. As a result, the assessment of downside risks to economic growth in Europe also increased, and the near-term growth outlook for the euro area was also revised downwards in early 2025.

Table 1. Eurosystem projections for euro area average GDP growth in 2025 (%)

December 2024

March 2025

June 2025

September 2025

December 2025

1.1

0.9

1.0

1.2

1.4

Source: ECB.

In June, the ECB attempted to quantify US tariff-related risks for the euro area economy using base and alternative scenarios. It treated the shock as a combination of higher US tariffs, heightened trade policy uncertainty and, in the adverse case, the EU’s retaliation. According to the assessment, in the adverse scenario, euro area GDP growth was expected to decline, cumulatively, by around 1 percentage point below the baseline over three years, with demand weakening as a result of higher tariffs and persistent policy uncertainty.

In addition, downside risks to growth were associated with potential export diversion: according to the ECB's assumptions, US trade restrictions could reduce US imports from China by around 10% and part of the displaced supply would in this case be redirected to Europe. As a result, euro area imports from China would be increasing by 2–3%.

In response to the increasing downside risks to growth, which also led to risks of inflation falling below the Eurosystem's target, the further easing of monetary policy that started last year continued in the first half of 2025. The deposit facility rate was reduced from 3% at the beginning of the year to 2% in June, and the members of the Governing Council of the ECB publicly expressed their determination to continue to do whatever is necessary to achieve the objective of price stability and to react promptly to incoming economic data.

However, incoming statistical data in the second half of the year showed a strong resilience of the euro area economy to external shocks. The actual maximum tariffs also turned out to be lower than assumed in the negative scenarios and lower interest rates were also supporting economic growth. As the economic situation improved and confidence increased that inflation would be sufficiently close to levels consistent with the Eurosystem's price stability target in the foreseeable future, the idea of monetary policy being in a good place was increasingly voiced in the public speeches of the members of the Governing Council. Market participants' expectations about the future path of interest rates also adjusted towards lower levels than at the beginning of the year.

Chart 1. 1-month euro money market forward rates resulting from interest rate swaps (%)

Sources: Bloomberg LP and Latvijas Banka's calculations.

While market expectations at the end of 2025 implied stable interest rates for the foreseeable future, which are in line with the ECB's baseline scenario in the euro area economy, the possibility of risks materialising in both directions remains significant. Therefore, in line with the current analytical approach, statistical data will continue to play an important role in the path of rates.

On the one hand, geopolitical risks and related uncertainties continue to play an important role, although they have declined following the highest levels observed in recent history. With high uncertainty weighing on economic growth, medium-term inflation in the euro area may also fall below the ECB target.

 

Chart 2. Global trade policy uncertainty and European economic policy uncertainty (index; 3-month moving average)

Source: Economic Policy Uncertainty Index.

On the other hand, while headline inflation in the euro area is close to the Eurosystem's target, it has come at the expense of a negative contribution from falling energy and food price inflation. Meanwhile, services price inflation was persistent and above 2% in the second half of the year, after declining at the beginning of the year. In Latvia, inflation developments were similar: food price inflation declined, while services price inflation remained stable.

Chart 3. Price changes in different product groups (annual changes; %)

Source: Eurostat.

Accordingly, the monetary policy conducted by the Eurosystem must also remain vigilant and ready to react swiftly, if necessary, to the materialisation of both downside and upside risks.

At the same time, monetary policy, however successful it may be, cannot solve the structural problems that hinder economic growth in the euro area. While these challenges were precisely identified in the Draghi report published in 2024, only a small proportion of these proposals have been seriously examined to date, and an even smaller number of proposals have actually been implemented. Meanwhile, progress on key issues – a closer economic, fiscal, financial, and capital market union – is very slow. Closer integration of the euro area is therefore critical to strengthen the economic resilience of the euro area and preserve Europe's global role as a key geopolitical block, also in a changing external environment. The need for these structural reforms has also been made public by the Governor of Latvijas Banka on several occasions1Opening speech by Mārtiņš Kazāks at the Baltic Capital Markets Conference 2025 | Latvijas Banka
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.

The Latvian economy: while out of a freezing point, focusing on inflation and budgetary discipline is necessary

After a protracted period of stagnation in economic growth, Latvia's economic growth started to pick up gradually in 2025, especially in the second half of the year.

This was primarily due to a better-than-expected external economic environment. The worst projected scenarios for the development of foreign trade did not materialise, which had a positive impact on Latvia's exports. The overall export performance, despite adverse weather conditions, was significantly improved by exports of cereal products, as well as various electrical equipment and dairy products. In terms of services, rapid growth continued in the export of professional, technical, and other business services, as well as in the export of travel services, with an increase in the number of tourists.

  • It should also be mentioned that even more than three years after Russia's full-scale invasion of Ukraine, Latvian goods exports to Russia remain relatively high. Although trade with Russia continues by companies for which it was the main outlet before 2022, and its exit would mean the company going out of business, exports have decreased in this group. Additionally, some companies only started trading with Russia after 2022. Exporters are mostly companies in trade, transport, and manufacturing sectors.

Second, the acceleration in economic growth was also supported by higher government expenditure and investment, including to strengthen defence. This will have an impact on Latvia's economic growth, also in the coming years.

  • Latvijas Banka's assessment of the impact of defence spending on economic growth shows that an increase in Latvia's and other EU Member States' defence spending over a four-year period may increase Latvia's GDP by 0.7%. Latvia's increase in defence spending to 5% of GDP may contribute to growth of 0.4%. The relatively small GDP multiplier (0.32) results from the high import component of Latvia's military expenditure. In turn, increasing military expenditure by EU Member States can contribute to an increase in foreign demand and the opportunities for Latvia to engage in various stages of production chains, which in turn can contribute to the growth of the Latvian economy. Thus, the indirect impact of higher spending on defence in the rest of the EU could lead to an additional increase (0.3%) in Latvia's GDP.

Chart 4. Impact of defence expenditure on Latvia's GDP (deviation from baseline; %)

 Sources: Latvijas Banka's assumptions (June 2025) and an assessment using the DSGE model for Latvia.

Third, while labour supply remained tight, wage growth also remained robust in 2025, although it eased somewhat compared to the previous year. This robust wage growth also implied a faster than expected increase in inflation. Despite falling in the last two months of the year, inflation was higher in Latvia than in the euro area throughout 2025.

  • Food price inflation was particularly strong in Latvia in 2025. In the past, food price increases in Latvia were mainly driven by global factors, but domestic factors, including sustained increases in labour costs, started to weigh more on price increases in 2025.
  • Consumer price developments are usually closely linked to producer price developments. However, since 2022, consumer food prices have risen significantly faster than food producer prices. As a rule, after such periods of rapid growth, the relationship between these prices is adjusting in the opposite direction. Currently, such a ratio levelling off between producer and consumer prices has not been observed for an extended period of time.
  • There is a similarity in the prices of food products in the major retail chains. Moreover, in the lower part of the price spectrum, many food products (the same brand, identical packaging, and one retail network) are much more expensive in Latvia than in Estonia and Lithuania, which suggests insufficient competition.

Chart 5. Food price dynamics in Latvia and on average in the euro area (annual changes; %)

 Source: Eurostat.

Lending also provided a positive boost to economic growth. After several years of stagnation, lending growth accelerated significantly in response to changes in monetary policy and improvements in financial conditions. Outstanding loans to non-financial corporations grew by 15.3% and outstanding loans to households by 9.9% in 2025. Thus, economic growth in Latvia was supported not only by consumption, but also by investment, which, together with efficient use of EU structural funds, will allow for the basis of sustainable long-term growth.

  • The Latvian DSGE model estimates that the growth in lending observed over the past two years has already supported real GDP growth by about 1.5%, mainly due to an increase in outstanding mortgage and investment loans. If lending activity continues at its current pace in the future, its cumulative contribution to economic growth could reach up to 3.4% by the end of 2028.

Although this dynamic is clearly positive, much remains to be done to ensure that the recovery in lending is not a temporary phenomenon but a lasting pillar of economic growth. This was also the topic of Latvijas Banka's Economic Conference 2025. The conference concluded that several steps had been taken in recent years to boost lending activity, including by ensuring the presence of banks in the regions and increasing competition in lending through a refinancing initiative. At the same time, the conference highlighted the potential for further improvements in access to loans and making loan conditions even more attractive for borrowers.

Although interest rates on loans in Latvia have decreased, they are still among the highest in all euro area countries. Latvijas Banka's analysis shows that this is due to a number of factors. Higher lending rates to non-financial corporations in Latvia are not associated with more expensive bank funding or weaker bank financial position. On the contrary, Latvian banks are well capitalised and raise financing relatively cheaply. The credit risk of non-financial corporations in Latvia is also only slightly higher than in the euro area and is not significant enough to explain the interest rate differential. Overall, the difference in interest rates between Latvia and the euro area is mainly determined by banks' supply-side factors: the main reason for the high interest rates on loans is lower competition in the Latvian banking sector, which allows banks to maintain higher rates, as well as different credit pricing practices. Moreover, interest rates on loans to non-financial corporations remain high, even though, according to the results of Latvijas Banka's analysis, the collateral requirements for comparable loans are among the strictest in the euro area.

Chart 6. Rates of loans to non-financial corporations and factors affecting them: Latvia vs the euro area (percentage points)

Sources: ECB (IBSI, IMIR), Bloomberg LP and Latvijas Banka's calculations.

 

The main aspects that may contribute to a reduction in lending rates in Latvia in the future are:

  • new market entrants;
  • new types of loans, including with different loan pricing mechanisms;
  • the elimination of unnecessary bureaucracy and overregulation at the national level.

In addition to analysing the current challenges of lending and inflation, in 2025 Latvijas Banka also studied the medium- and longer-term challenges of the Latvian economy.

First, the economic shocks experienced in recent years and the ensuing supportive fiscal policies led to higher deficits and higher than usual increases in public debt. The pressure to increase budgetary expenditure will remain in the coming years, taking into account the need to strengthen national defence and security, as well as to invest in demography and education. Against this backdrop, reliance mainly on external financing poses significant risks to the sustainability of public debt in the medium to longer term.

  • According to current projections, the government debt level will have reached 55% of GDP in 2028 and the deficit will exceed 3% of GDP. At the same time, a number of temporary conditions and derogations that allowed fiscal policy to remain accommodative in the past (including the possibility to temporarily exceed fiscal constraints) will come to an end. This will increase pressure to pursue more restrictive fiscal policies. A Latvijas Banka's assessment on a possible budgetary consolidation of 1.2% of GDP in 2029 indicates that the scenario in which expenditure cuts go hand in hand with cuts in the number of public sector employees, some of which move into the private sector, is the least unfavourable for the Latvian economy in the medium term. However, this option is also one of the most difficult due to the need for a targeted approach and timely preparations. It also includes a support mechanism for the retraining of employees to ensure their effective integration into the private sector labour market. If there is no transfer of public employees to the private sector, this becomes one of the most economically unfavourable consolidation solutions. In terms of impact, this equates to linear spending cuts, with limiting public investment being one of the most economically inefficient consolidation paths. The second least unfavourable solution for the economy is to raise taxes on consumption. Meanwhile, revenue increases by raising all taxes, including on labour, have the greatest negative impact on the economy in the medium term.

Chart 7. The impact of consolidation on Latvia's GDP: cumulative deviation from baseline (%)

 Sources: Latvijas Banka's assumptions (December 2025) and an assessment using the DSGE model for Latvia.

Secondly, in view of the plan to introduce ETS2 from 2028 onwards, researchers at Latvijas Banka explained in their 2025 macroeconomic forecast reports how the system would work and how it would affect commodity prices and inflation, as well as analysed the potential impact of changes on the Latvian and euro area economies using the tools of green models developed by Latvijas Banka.

  • Simulations with the multidisciplinary E‑DSGE2Grüning, P., Kantur, Z. Financial Intermediation and Climate Change in a Production and Investment Network Model for the Euro Area. Latvijas Banka Working Paper, 6/2024, p. 94.
     model and the improved CGE‑EUROMOD3Beņkovskis, K., Jaunzems, D., Matvejevs, O. A Purpose-Based Energy Substitution Structure for CGE. Latvijas Banka Working Paper, 7/2023, p.44.
     model with an enlarged energy sector led to the conclusion that the economic impact of ETS2 is highly dependent on the use of the revenues it collects. The results obtained show that shifting carbon tax revenues towards increasing renewable energy production capacity in the medium term fully compensates for the negative macroeconomic impact of raising the carbon price, while reducing GHG emissions at a much faster pace than if tax revenues would be used in other ways, including by reducing VAT rates or increasing public consumption.

Thirdly, the experts of Latvijas Banka also offered concrete proposals for the solution of demographic problems and dedicated an expert discussion to them. The main conclusions of the discussion were as follows:

  • Demographic change is a long-term process influenced by birth, mortality (including avoidable deaths), and migration, while demographic trends have a significant impact on the labour market and labour supply.
  • Both the downward trend in the birth rate (although still higher than in many EU Member States) and the decline in the number of women of reproductive age are contributing to the decline in fertility.
  • An increase in fertility cannot be achieved in the long-term through a single measure and requires coordinated policies.
  • Research-based examples show that regular reviews of benefits and the reduction of the risk of poverty in families, as well as the extension of early-age childcare facilities and support for the post-birth family, can significantly improve birth rates, especially in the long-term, and have a positive impact on the overall number of children in the family.
  • Health policy measures, including the extension of the reproductive health programme, and the access to a housing programme, especially for young people, also have an equally positive impact.

  

Research: focus on lending and sustainability issues

The in-depth research carried out by Latvijas Banka in 2025 provided evidence-based conclusions and policy proposals on a number of topics relevant to the Latvian and euro area economies, focusing mainly on issues related to the functioning and long-term resilience of the financial sector. During the reporting year, Latvijas Banka published nine studies and three discussion materials. Researchers of Latvijas Banka were authors of six research papers published in international scientific journals, including The Scandinavian Journal of Economics, and co-authors of several ECB publications.

Researchers of Latvijas Banka led an international project that documented differences in lending practices across euro area countries. Using detailed data on almost 7 million loans granted to non-financial corporations between 2022 and 2023, the study illustrates the wide variety of lending practices across euro area, including the prevalence of fixed and variable rates as well as differences in the maturities of the reference rates that are used for pricing loans. The results of the study show that the strength of transmission depends on which risk-free rate is important for a given loan. Loans linked to short-term risk-free rates react more strongly to changes in monetary policy. However, this reaction is not purely mechanical: banks partially offset the increase in risk-free rates by adjusting the mark-ups. The results of the study help to improve understanding why changes in monetary policy do not have an equal impact on the economies of all euro area countries.

Another study concluded that the interest rate increases implemented in 2022 and 2023 had a significantly stronger impact on inflation than previous monetary policy tightening cycles. Moreover, it is important that disinflation during that period was achieved without an excessive slowdown in economic growth and an increase in unemployment. Thus, the sacrifice ratio between output and inflation stabilisation was at historically low levels.

In the area of monetary policy, another study by Latvijas Banka analysed how banking specialisation interacts with the transmission of monetary policy to loans. The study revealed that bank lending in the euro area is characterised by a significant degree of specialisation. This means that banks tend to create large exposures by lending to borrowers of certain sectors and sizes. The study also concluded that higher specialisation tends to be linked to more favourable lending conditions, as well as to the fact that banks tend to shield their existing borrowers from the effects of monetary policy.

These and other studies were carried out within the framework of the ECB's ChaMP Research Network. This demonstrates the high quality and relevance of research in the context of the euro area. The results of these studies have been recognised at international scientific conferences and seminars while also being used in ECB reports on monetary policy transmission.

Researchers of Latvijas Banka also continued to analyse the dynamics of lending in Latvia. Part of this analysis is reflected in a discussion paper which explains the dynamics of lending to non-financial corporations over the past 10 years by comparing it with the dynamics of lending in the euro area. The study concludes that lending activity in Latvia remains significantly below the long-term average even more than 15 years after the financial crisis. This is mainly driven by limited loan supply. However, as of 2024, the situation has started to improve. During this period, the Governing Council of the ECB started to reduce interest rates, which had a positive impact on lending developments in Latvia. Banks' risk perception with regards to lending to non-financial corporations has also gradually started to ease.

Chart 8. Historical decomposition of lending to Latvian non-financial corporations (deviation from the long-term average (%) and contribution of shocks to a change in the indicator (percentage points))

 

A study on how Latvian companies responded to the trade shock caused by Russia's 2022 invasion of Ukraine was also published in the reporting year. The study concluded that those companies, for which trade with Russia accounted for a smaller share of total turnover before the beginning of the war, had a much higher probability of completely breaking trade ties. Meanwhile, those companies for which the Russian market was significant continued trading, but faced a statistically significant drop in turnover, employment, and profits, despite a partial redirection of trade to CIS countries.

Against the background of rising government debt, researchers of Latvijas Banka and Eesti Pank conducted a study analysing the impact of macroeconomic and budgetary balance shocks on public debt in euro area countries. The study concludes that a sustained reduction in the debt-to-GDP ratio is supported by a positive economic growth shock or a positive budget balance shock (associated with fiscal consolidation). The impact of the inflation shock on public debt, on the other hand, is temporary. Fiscal consolidation is more effective in times of high economic growth, but not in a recession. On the other hand, the shock effect of positive growth is stronger in a context of high levels of public debt.

Researchers of Latvijas Banka also analysed the effectiveness of state aid instruments in improving the energy efficiency of housing and assessed their impact on real estate prices. It was concluded that the price of apartments renovated under the energy efficiency programme for multi-apartment buildings was, on average, 11% higher than the price of non-renovated apartments equivalent in other parameters. In addition, the average renovation return for the seller of the apartment was around 10%. This renovation return depended on the level of efficiency achieved: it ranged from 6% (with an efficiency improvement of 30–45%) to up to 25% (if the efficiency improvement reached at least 60%). By contrast, investments in renovations were not profitable in Riga, partly due to higher renovation costs. Looking at a scenario in which grants would not be available, the results of the analysis confirm that most renovations in Latvia would not be economically viable without subsidies.