Thursday's decision by the Governing Council of the European Central Bank (ECB) to increase interest rates by 0.5 percentage points won't be the last, and interest rates will have to be raised higher than financial markets have been expecting thus far, Bank of Estonia Governor and Governing Council member Madis Müller warned in a comment issued Friday.
"The Governing Council of the ECB decided yesterday to raise its interest rates by 0.5 percentage points," Müller wrote. "We did this in the understanding that we will need to raise interest rates further in the future, and probably higher than financial markets have been expecting thus far. It is not currently evident that inflation in the euro area will come back down to close to 2 percent quickly enough with interest rates at their current levels."
According to Müller, the ECB will also start to shrink the balance sheet from March, and thus reduce the footprint of the central bank on bond markets, and this is expected to push long-term interest rates up a little. "This will dampen general economic activity, and thus help reduce inflation, as long-term interest rates affect investment decisions above all," he said.
Nonetheless, the outlook for inflation "regrettably offers little good news," he continued.
The latest forecast by the ECB finds that strong upward pressures on food prices in particular will endure in the euro area next year, he noted, adding that inflation in the prices of other goods and services in the euro area will probably remain higher than they expected three months ago as well.
"Rising wages in the euro area are giving support to this inflation," Müller explained. "Economists at the ECB forecast that inflation in the euro area will be 6.3 percent next year and 3.4 percent in 2024. The outlook for economic growth in the euro area has weakened somewhat to 0.5 percent in 2023, from the earlier forecast of 0.9 percent. The economy may contract in quarterly terms in the fourth quarter of this year and first quarter of the next."
According to the Bank of Estonia governor, the reduction in purchasing power that has been caused by high inflation will be eased next year by wage increases in the euro area climbing above 5 percent.
"Rapid wage increases, however, are a double-edged sword from the long-term inflation perspective," he warned. "It is entirely understandable that people expect rapid rises in prices to be compensated as much as possible by rising incomes. At the same time, however, the general strengthening of demand that accompanies wage increases is an obstacle to reducing inflation, and it would be dangerous to fall into a continuing spiral of rising prices and wages. We do not, however, need to fear that currently."
Fiscal policy will also have a major effect on prices, particularly attempts to soften the impact of high energy prices, Müller said, noting that measures taken in the euro area as a whole to ease the impact of inflation will total almost 2 percent of GDP this year and next.
"A large part of the measures decided on by the government have been aimed at setting a ceiling for energy prices, and they will push inflation a little lower in 2022 and 2023," he explained. "We can expect to see the opposite effect when the price ceiling is lifted, though, which will likely be from 2024. A policy based on widescale subsidies and budget deficits will understandably make it harder to get inflation under control."
This is the reasoning for central bankers' recommendation that various support packages should be sufficiently well targeted, should encourage reductions in energy consumption and should only be temporary, he added.
Recovery in confidence may not happen as quickly as expected
"I quoted the numbers forecast by the ECB, but there remains a lot of uncertainty and a lack of clarity about the outlook for the economy," Müller wrote. "The war in Ukraine is seriously affecting markets for energy and other commodities. A recovery of growth in the economy assumes a recovery in confidence, which may not happen as quickly as we currently expect."
Several trends in the Estonian economy are similar to those occurring in larger European countries, though they are amplified in a small economy, he said.
"The recovery of the Estonian economy from the pandemic and the subsequent relative slowdown were much faster than average in the euro area, while inflation has been higher and the rise in the average income of people in Estonia has been almost double that in the euro area," he highlighted. "The rise in incomes, however, is unfortunately only partially able to offset the reduction in purchasing power caused by inflation."
The Estonian economy can still be expected to start growing next year, and with that, the purchasing power of people here will gradually recover.
"Understanding the extent of the problems caused by consistently high inflation, the decline in purchasing power and in the value of savings keeps the ECB firmly on its course of raising interest rates," Müller said.
"We cannot simply hope that the expected slowdown in economic growth will alone be enough to sufficiently reduce inflation, and so borrowers need to consider further increases in interest rates in the future," he acknowledged. "This may be painful in the short term, but it will prevent inflation from remaining high for a longer time, and thus will support purchasing power over the long term."
Editor: Aili Vahtla