The outlook for the Estonian economy depends, above all, on the future rate of inflation. Estonia currently has the highest rates of inflation in the Euro zone, and so the rises in production costs and cost of living are putting noticably more pressure on the resilience of the national economy according to a Bank of Estonia (Eesti Pank) press release.

Bank of Estonia is forecasting that inflation this year will be around 19 percent, mainly because of higher energy costs. Inflation is expected to fall to close to 7 percent next year, and to 2 percent in 2024. The inflation forecast takes into account the European Central Bank tightening monetary policy, which will make borrowing more expensive. The government is also planning to regulate energy prices, which will, to an extent reduce overall levels of inflation.

According to Bank of Estonia, while the Estonian economy was performing better than expected in the first half of 2022, inflation will have a much bigger affect in the second half of the year.

The supply problems that expected as a result of sanctions imposed on Russia for its military aggression against Ukraine remained smaller than feared, and, despite a sharp rise in prices, consumption levels increased.This is largely due to consumers' use of savings to cover the increased costs. However, this will not be possible to the same extent in the future, meaning consumption levels are expected to decline.

Bank of Estonia predicts that the economy will shrink by 0.5% for the year as a whole, before growing by around 1 percent in 2023, and 3.5 percent in 2024. However, in the light of ongoing geopolitical instability, there is greater uncertainty than usual surrounding the outlook for economic growth and also for inflation.

Despite the recession, Bank of Estonia expects the labor market to continue performing well. Since there will continue to be a labor shortage, and both the minimum wage and prices in general will continue to rise, wage growth is predicted to remain strong both this year and next, even as the labor market cools a little.

According to Bank of Estonia, the average gross monthly wage will rise very fast this year and in 2023, with increases of more than 10 percent. However, the purchasing power of real wages will only get back to its 2021 levels at the end of 2024.

Unemployment is expected to remain around 6.5 percent this year, and should rise to 8.6 percent in 2023. However, this increase is based on the assumption that a a significant number of Ukrainian war refugees who are seeking work, will be added to the overall labor market statistics.

As the Estonian economy is very open, the performance of the export sector is important. Weak export markets will be compounded by the impact of sanctions on Russia on trade and production, which will in turn hinder Estonia's economic activity.

According to Bank of Estonia, export orders have already dropped, and, at a time when the whole of Europe is offering assistance packages to help cope with the energy crisis, it is crucial that Estonian business do not lose their competitiveness against those in other countries.

In order to slow down inflation, the European Central Bank will raise interest rates. The Governing Council of the European Central Bank has raised monetary policy interest rates to bring down inflation in the Euro zone, and the current assumption is that, in future, it plans to increase them further.

As a result of this, the rising Euribor will push up the cost of borrowing for Estonian households and companies, cooling the economy and so slowing inflation levels, particulalry for manufactured goods and services.

However, Bank of Estonia also says, that the impact of rising interest rates on prices is only fully felt after around a year, and, regardless, inflation cannot be brought under control through monetary policy alone. A major factor behind high inflation in Estonia and in the Euro zone as a whole, is problems on the supply side, especially in the issue of the several-fold increase in energy costs.

Fiscal policy has an important role to play in reducing pressure related to price rises. During a recession caused by higher energy prices, increased state spending will not resolve the problems facing the economy, but will instead add further momentum to rising prices, according to Bank of Estonia.

Instead, additional government spending is required to both ease the energy crisis temporarily and resolve it in the longer term, as will receiving war refugees and strengthening the national military defence.

The budget is currently deep in deficit, and even without those extraordinary expenses and despite tax revenues, continues to grow very fast. If Estonia remains on the same course, the fiscal deficit will deepen in the coming years and most likely cause inflation to rise further.

Core inflation in Estonia without energy and food prices has exceeded 10 percent over the year in recent months, making it the highest in the Euro zone. It is directly affected by fiscal policy and consumption levels within the economy. This means there is a danger that the competitiveness of Estonian companies may start to decline, not only due to high energy prices, but also as a result of additional price pressures resulting from the choices made about how to use state finances.

Bank of Estonia will publish the full version of its economic forecast for 2022-2024 on September 28.

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