The growing confidence in the sustained slowdown of inflation allows the European Central Bank (ECB) Governing Council to continue lowering interest rates, even if monthly indicators still exhibit considerable volatility. This conviction also guided our Thursday decision to reduce the ECB's interest rates for the fourth time this year, by 0.25 percentage points.

In October, consumer price growth in the euro area matched the ECB's target of 2 percent. However, in November, inflation accelerated to 2.3 percent year-over-year. Such short-term statistical fluctuations can largely be explained by changes in the base of comparison from a year ago, rather than by a sharp increase in prices over the past month. Inflation in the euro area is clearly on a path of deceleration.

The euro area's economic outlook has not changed significantly compared to the assessments made in September. We can expect a moderate economic recovery driven by income and consumption growth. With a slight lag, an increase in investments is also likely.

This expectation, that the gradual recovery of the euro area's economic situation will be driven by consumption growth at least over the next year, is confirmed by recent data. For example, retail sales of goods and services have already rebounded due to improved purchasing power among consumers.

The euro area's economic outlook remains broadly similar to that of September: moderate economic recovery, led by growth in incomes and consumption, can be expected.

However, business confidence and short-term outlooks remain modest across the euro area, similar to the situation in Estonia. Industrial companies, in particular, continue to face relatively challenging conditions.

The competitiveness of European businesses has undoubtedly suffered somewhat in recent years in a global context, primarily due to higher energy prices. In Estonia and other Baltic states, the challenges related to competitiveness have been further exacerbated by even faster inflation, which has driven up operating costs for businesses.

The euro area continues to experience relatively rapid average wage growth, accompanied by corresponding increases in the prices of services. Recent wage negotiations by trade unions, particularly in Germany, have resulted in substantial wage hikes.

Looking ahead, however, it is likely that wage growth across the euro area will slow. The loss of purchasing power caused by rapid inflation in recent years has largely been offset by recent wage increases. Current wage growth, however, has come at the expense of reduced profitability for businesses, a dynamic that is quite similar in Estonia.

A significant uncertainty lies in potential changes to trade policy following the inauguration of the new U.S. president. While the exact nature of these changes remains unknown, various scenarios can be imagined. However, it is too early to incorporate them into specific economic forecasts. What is clear is that any restrictions on free trade generally suppress economic momentum and wealth creation. Similarly, the imposition of tariffs typically leads to higher prices.

As I have mentioned in previous comments following central bank decisions, Estonia's borrowers and the economy as a whole benefit relatively more from interest rate reductions than most other euro area countries. This is due to several factors: the widespread use of Euribor-linked interest rates in loan agreements, the faster decline in Euribor rates compared to the ECB's decisions and the relatively higher debt burden of Estonian households and businesses compared to, for example, other Baltic states.

The six-month Euribor has dropped from 4.1 percent in the fall of last year to around 2.6 percent. This decline gradually reaches borrowers, as interest rates in contracts are reviewed every six months.

For example, a family with a €100,000 outstanding home loan will see their monthly loan payment decrease by approximately €50-60 for every one-percentage-point drop in the interest rate, depending on the loan's term.

Considering the total amount of home loans, leases and business loans taken out by Estonians, it is possible to estimate that borrowers in Estonia will retain approximately €300 million more next year due to falling interest rates. This calculation is based on financial market expectations for the extent of the Euribor decline and the time lag with which interest rate changes affect borrowers.

The amount saved on loan payments allows individuals to spend more on other needs, reducing financial pressure on businesses. At the same time, lower interest rates mean smaller returns for savers, but the financial volume affected by this is significantly smaller in comparison.

How might the economic well-being of the average Estonian individual or family change next year?

According to the latest forecast by the Bank of Estonia, average wage growth is expected to be 5.9 percent next year, while inflation is projected at 4.3 percent. This inflation includes the effects of indirect tax increases, such as higher VAT, vehicle taxes and excise duties. Income tax rates will also rise, meaning that the purchasing power of the average post-tax wage will not increase.

For families with loans, relief will come from the aforementioned decline in interest rates. Taking this into account, the average disposable income purchasing power of Estonians is expected to improve by more than 1 percent next year. Of course, the actual situation for each individual or family will vary depending on how much their income growth differs from the average, whether they have loans, and how their spending patterns differ from the average.

The comment was originally published in the Bank of Estonia's blog.

--

Follow ERR News on Facebook and Twitter and never miss an update!