Central bank: Estonia can hopefully avoid recession

Bank of Estonia vice-president Ülo Kaasik.
Bank of Estonia vice-president Ülo Kaasik. Source: Siim Lõvi /ERR

Bank of Estonia vice-president Ülo Kaasik told ERR in an interview that the energy price shock will affect Estonia's economic growth indicators negatively, but it is still too early to assess how bad the setback will end up.

Midway through January 2022, can we be sure that Estonia's economic growth will not happen and there could even be quarters with recession?

What is true is that there is a lot of uncertainty. The coronavirus crisis was the main source of uncertainty in the two previous years, now energy price inflation brings additional uncertainty. Several entrepreneurs have had a complicated time managing this price shock, especially if their competitors have signed cheaper contracts.

Consumers will also begin reducing their other expenses, because bills need to be paid. Will this become another spiral pulling the economy down?

It can have an effect, but it is much too early to say if the price shock has been that great. Consumers have been forced to save up due to the coronavirus the last few years. Additionally, people received their withdrawn second pension pillar funds at the end of last years. Household consumption capacity has been pretty good.

But it was good until last November, when utility bills began rolling in. Those scared quite a few people.

Yes, it has certainly been a scare to many. But again - it has not hit everyone the same way, we know about half of the consumers are on fixed-price contracts. They have not actually seen the high electricity prices on their bills yet.

They will!

Yes, they will and the effect is already there psychologically, because there is a lot of talk of bills. Modest people are already considering it in their consumption decisions to save up for the future. Utility bill increases certainly have their negative effect, but it still early to assess the size of that effect.

Secondly, the general tempo of the economy last year was very fast, the exports sector did very well, the IT sector did very well. We should be able to put two things on the scale.

Firstly, how long will this good pace and inertia keep things growing versus the negative messages that slow us down. We can see from a quarter-by-quarter comparison that growth has stopped or even decreased. Hopefully there is not a decrease for the whole year.

How much has Estonia's competitiveness fallen due to price inflation? We had the highest inflation in the EU alongside other Baltic countries.

I think there is that risk in some sectors. But the growth of energy prices and gas prices has taken place all over Europe. Therefore, our competitiveness should not get worse compared to others. But Estonia has recovered from the crisis much faster and our general conjuncture has favored rapid wage growth.

And managing wage growth is much more complicated for companies, especially those with a high share of labor costs. The Bank of Estonia has stated that rapid input cost increases can destroy the competitiveness of our companies. And therefore, the government should be careful with additional expenses. True, energy prices will likely not be affected, but labor costs, construction prices and other domestically affected pressures can be pulled down by the government, if they spend less.

As a central banker, are you glad that there are female politicians from Reform Party, who look up to Bank of Estonia board chair Mart Laar, in key government positions? Especially Laar's very rigid monetary policy?

I mentioned earlier that we have had very rapid economic growth up until this point. If the government were to give the economy even more of a boost in the current phase, we will not only be complaining about energy prices, but inflation will bring forth an even bigger price increase in other sectors, as well.

If the government establishes new measures, the budgetary deficit should not increase. The government will receive additional revenue from higher electricity prices, Eesti Energia's profits or the CO2 quota sales. The government should remember this simple rule: if you support, then not in excess of the additional revenue received by the government.

Who to support? Companies or people?

It is more reasonable to support people in trouble. For companies, the first question should still be what their entrepreneurial risks were? We must always consider fair competition throughout the European Union when supporting companies.

I actually came to the central bank to investigate if there is a new dark cloud on the horizon - increased interest rates? Younger home loan applicants might not know that interests could be significantly higher. In 2007, Euribor was 4 percent, which would increase monthly payments for a €100,000 by €300. Is this coming because interest rates must be increased to handle inflation?

The central bank's interest rates have historically never been close to zero. The negative interest rate stems purely from the low inflation rates in the eurozone over the last decade. There have been significant measures taken to support economies. With inflation jumping up again, a key question arises: is this temporary? We should react accordingly. If inflation will remain around 2 percent in the long-term, interest rates will certainly increase.

The central bank does not direct inflation in the upcoming months. We can direct it looking forward several years. We look at economic analyses, try to understand where the inflation indicators can go and what the price pressures are in the economy. And implement our monetary policy accordingly. If the current price shock is temporary, then inflation might not even climb so high in the eurozone.

The eurozone's economy is still recovering from the coronavirus crisis and there is no need for strict monetary policy. But if energy prices carry over to other prices, the euro area economy and labor costs are growing rapidly, the central bank will have to take earlier decisions to tighten monetary policy.

So when the European Central Bank's Pandemic emergency purchase program (PEPP) wraps up in March, nothing special will actually happen in April?

[PEPP] will end in March, but there are purchase programs from earlier. The ends of those have not been communicated yet. A new decision is needed for that. And interest rates will certainly not be increased before these debt purchase programs are dropped.

Currently, worrying about commercial bank profits is not a popular activity. But commercial banks hold very large sums of money in the central bank with negative interest rates, this means the money is quietly melting. And at the same time, inflation in Europe is 4-7 percent. How long will they tolerate that?

That is their worry. The earning capacity of commercial banks largely stems from them borrowing through deposits in the short-term to then loan that money out over a longer period of time. The question is the difference between those two interest rates. But they themselves have an opportunity to borrow from the central bank with negative interest. Actually, we are paying them to borrow from us! The goal of that is to pump as much cheap money into the economy as possible to support the economy, which is in a crisis. In the summer, this deep negative interest support program should end. Commercial banks will no longer be able to get money on such conditions from the central bank.

Europe's economic and financial locomotive is certainly Germany. Their inflation is more than 5 percent. The German press is demanding the European Central Bank to move itself faster. Do you feel pressure to raise interest rates?

In all countries where inflation is highest and things are actually going better than the eurozone average, there is a sense that monetary policy should react faster. I think that is how we feel in Estonia - if inflation is already at 12 percent, why does the European Central Bank already understand that action needs to be taken?

But then you must understand that monetary policy is established across the eurozone. It is impossible to implement one interest rate to German banks and another to Italian banks.

But it is true, inflation risks have increased and if they come to realization, the central bank will have nothing else to do but tighten monetary policy. First, purchase programs will be ended, after which interest rates need to be increased.

When will interest rates hit zero and when will they change?

Markets expect zero to come next year.

Did we overreact to the coronavirus crisis fears? Printed out too much money?

I think we should look even further back. The money print trigger was actually the European debt crisis, the long period of extremely low inflation. Central banks used measures to increase inflation. Actually, we still cannot say we reached a bad result.

Now, we are carefully monitoring if the sharp increase in energy prices carries over to other sectors. But we think it would be very bad if we reacted to this one price shock and cause an economic crisis. For example, complicating loan conditions - we do not want to put useless pressure on the economy. Therefore, a careful approach.

Lack of energy is a deepening issue and not just in Europe. Growing economies in Asia require more gas, require more crude oil, require more electricity. This issue regarding energy prices will stick around for a while, could inflation in Europe be around 5 percent for several years?

We should certainly react fast if long-term inflation is more than 2 percent. The last estimates actually stated that the expected inflation is less than 2 percent. We do not see there being any additional pressure on inflation from energy prices, oil prices in terms of futures should even fall slightly.

But it is true that we are looking at a green transition, where we will drop certain energy sources. This likely means additional pressure on energy prices. Therefore, we have said that risks for inflation go upward - if we see the realization of such risks, we must react.

Would it be in Estonia's interests if the euro got cheaper? Our products and services outside of the eurozone would get more competitive?

I do not think the currency question in the eurozone is an issue. Macroeconomic stability is significantly more important. If the euro were to get significantly cheaper, this will only bring additional inflation pressure.

What does the European Central Bank fear most then? If interest rates were increased, southern Europeans would just not be able to service their debts?

Yes, there are certainly risks. We must take how countries manage their debts into consideration when interest rates grow. Secondly, higher inflation will alleviate debt risks for countries with debt, because the debt burden will decrease. What can we do, there are very different economies in Europe, this does not make policy-making any easier.


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Editor: Kristjan Kallaste

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