According to the Bank of Estonia's forecast, inflation in Estonia will remain high this year due to increased production costs and tax hikes, reaching 5.4 percent. Over the next two years, price growth is expected to hover around 3 percent.

In its latest forecast, the Bank of Estonia notes that the data on the country's economic performance this year is somewhat contradictory. Statistics Estonia revised its initial estimate of first-quarter economic growth from a 1.2 percent increase to a 0.3 percent decline.

"Based on that indicator, the economic recovery that began last year suffered a setback. On the other hand, strong growth in industrial output and exports, as well as increased electricity production and construction volumes, suggest continued economic revitalization. This trend is also reflected in private sector lending activity for new transactions, the slowing decline in employment and the growth of retail sales volumes," the central bank commented.

Future economic growth will be difficult to achieve. According to the Bank of Estonia, growth will be supported by lower interest rates and financing costs, cheaper energy and underutilized production capacity and labor, which allow productivity to rise quickly when new orders come in. A rise in order volumes is expected as foreign demand improves, although trade restrictions mean this will happen more slowly than previously anticipated.

The central bank sees only limited direct impact on Estonia from U.S. customs and trade policies. The more significant effects are expected to be indirect, via other export markets.

The slow economic recovery does not promise a rapid increase in employment or a decline in unemployment. Labor costs and the average gross monthly wage will continue to rise, though at a slower pace. "Next year, the so-called tax hump will be eliminated, leaving households with more disposable income, and purchasing power will also be supported by a slight easing of inflation," the Bank of Estonia predicts.

Inflation is expected to remain high this year due to rising production costs and tax increases. The Bank of Estonia notes that companies have now passed on higher wage and other production costs into the prices of their goods and services. Combined with the introduction of a vehicle registration fee and increases in value-added tax and excise duties, this will push the overall price level up by 5.4 percent this year. Next year, inflation is projected to fall to around 3 percent and is expected to remain at that level in the following year as well.

"Price pressures will be eased by slower wage growth, a stronger euro, lower expected oil prices and more moderate food commodity price increases — or in some cases, even price declines," the Bank of Estonia added.

Coalition agreement's effect on economic situation

The Bank of Estonia also notes that changes to the government's coalition agreement could affect the country's economic outlook. Of the proposed changes in the agreement, the impact of increasing defense spending and amending the security tax legislation can be assessed more precisely. Implementing these measures would raise the budget deficit by about 1.5 percent of GDP.

"The international economic environment remains fragile, and should it deteriorate further, the fiscal situation could become even more strained than currently projected. With a view to the long-term outlook of public finances, it remains important for the government and parliament to seek ways to curb the growth of debt and interest expenses," the Bank of Estonia's analysts recommend.

By 2027, the state's interest expenditure could reach €320 million, or 0.7 percent of GDP, accounting for 1.6 percent of total general government expenditures. That would exceed, for example, the Ministry of Economic Affairs and Communications' budget for business development.

"A sound guiding principle would be to ensure that the budget position does not deteriorate in the coming years beyond the additional defense spending. If high defense spending continues over a longer period, it should be permanently funded from the state's regular revenues."

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