The sharp rise of inflation has created new challenges for the economy

At the same time, business sentiment in the United States, the euro area and the world as a whole remains positive, with the global economy continuing to grow and recover from the COVID-19 pandemic. Although the economic recovery is incomplete, the unexpectedly sharp rise in inflation has become a major political issue, forcing governments to implement measures to reduce prices and for central banks to raise interest rates. Russia's invasion of Ukraine and China's severe restrictions on COVID-19 are further shocks to the global economy, which have fueled further inflation and disrupted global production chains even more. These developments are increasingly affecting the economic growth projections considered in this review. For example, in April 2022, the International Monetary Fund again reduced its global economic growth forecast for 2022 from 4.4% to 3.6%.

For the first time since the 1980s, strong inflation has returned in the developed world and prices have risen much faster than expected over the past year. Consumer price inflation in the US and Europe has reached 7-8%, in our region the rise in prices is already well above 10%, while in producer price inflation in many European countries has reached 30%. The biggest economic support measures since World War II and Russia's invasion of Ukraine are the most obvious reasons why inflation has risen much faster than expected. However, it is not just one or two factors, but the coincidence of many events. Inflation in the world, Europe and Latvia is currently mainly driven by rising prices for food, energy, metals and various other natural resources. Global natural resource prices have almost doubled since the end of 2019, although the US and eurozone economies have only slightly exceeded pre-pandemic levels in real terms. Economic growth has been very uneven over the last two years, and we now consume much more goods than before, but less services. Higher consumption of goods requires more resources and energy. At the same time, lockdowns, the wide-ranging COVID-19 restrictions, unexpected swings in consumption, extra barriers to crossing borders, and more frequent and prolonged sick leaves of workers have disrupted the global production system. Global oil prices are currently in the $100- $120 range, but the release of strategic oil reserves, the continued Russian oil exports and China's strict COVID-19 measures have eased price pressures on oil. It is therefore clear that inflationary pressures in the global economy are certainly not over.

Rising inflation, unlike, for example, a recession in some specific sector or a rise in unemployment, is politically challenging because it affects society as a whole at the same time. More expensive food, heat and fuel contribute to political instability, cause civil unrest and conflict, and inflation is a very good breeding ground for populism. Therefore, politicians and central banks are under a lot of pressure to limit price rises, but there are not many tools to do it. The US Federal Reserve has already started to raise key interest rates, and the European Central Bank could soon start raising rates as well. According to the financial market, the US could raise interest rates as much as 10 times this year and the base rates could approach 3% at the end of the year, while in the eurozone interest rates could exceed 1% in 2023. This would be the sharpest rise in interest rates in decades. In the last 80 years, the United States has only a few times managed to implement a so-called soft landing and raise interest rates without causing a recession.

Growth in new industrial orders in the global manufacturing is slowing, consumer sentiment has deteriorated significantly in many places, and the sharp rise in mortgage rates has begun to cool the US housing market. Financial markets are also worried not only about inflation, but also about growth, as indicated by the convergence of short-term and long-term interest rates. In the United States over the past 50 years, whenever short-term government bond yields have been higher than long-term rates, the recession has followed in a year or two. In Europe, meanwhile, very expensive energy resources pose additional risks to the economy. Natural gas prices in Europe are currently 4-5 times higher than in the US and raising interest rates will not help replace Russia's natural resources with other sources. In developing countries, in addition to high energy prices, soaring food prices, a strong dollar and rising US interest rates, which are increasing the dollar's debt burden, are also causing major problems. All this poses significant risks to global economic growth.

Economic growth in the Baltics remained strong in the first months of 2022, and the effects of Russia's invasion of Ukraine are largely felt only by rising inflation. In the 1st quarter of 2022, the GDP in Latvia grew by 6.7%, compared to the 1st quarter of 2021, in Estonia the GDP grew by 4.3%, while in Lithuania the GDP increased by 4.6%. The economic recovery in the Baltics has been faster than the euro area as a whole, and short-term economic performance is also positive. Since February 2022, the turnover of payment cards has increased, unemployment is decreasing, while the number of vacancies and job advertisements is increasing. Also, despite high prices, electricity consumption is higher than a year ago, indicating stable industrial activity. However, risks to economic growth in the Baltics have increased in recent months. Due to the war in Ukraine, the economic sentiment deteriorated significantly in March and April, industry needs to rapidly find suppliers of metals and other raw materials, wage growth lags behind price rises, while the full impact of inflation will be felt only in the second half of the year. Therefore, the risks of recession in the Baltic States in the next year or a year and a half are high.

Russia's invasion of Ukraine has led to an even sharper rise in world food, energy and other commodity prices. Inflation in the Baltic States has exceeded 10% for the first time since 2008, while in Estonia it reached 19% in April. The sharp rise in inflation in the Baltics is mainly due to rising global commodity prices, which will not diminish in the coming months. Heating costs will increase significantly in the autumn, as natural gas prices are currently 5-6 times higher than in previous years, while unfavorable weather conditions in several major food-producing regions of the world and high fertilizer prices create the potential for further global food price increases of 10-30%. Government support measures will help dampen price rises, but producer price inflation in the Baltics has reached 30% and pressure on consumer prices remains strong. However, while producer prices in the Baltics have risen as fast as in the euro area as a whole, consumer price inflation in the Baltics is almost two times higher than in euro area. The relatively higher level of consumer price inflation in the Baltics could be explained by the fact that we spend most of our income on food and energy, and we are feeling the rise in these prices more. However, this is certainly not the only reason. In recent years, wages in the Baltics have been growing faster than the economy, but low headline inflation has prevented businesses from passing on these price increases to consumers. Nowadays, everyone knows that prices are rising, so no one needs to explain the price increase, and companies may be taking advantage of this opportunity. Finally, it is possible that traders in the Baltic States have shorter supply contracts and less fixed prices with producers, so we feel the rise in world prices faster, as similar inflation dynamics exist in other Eastern European countries.

Retail sales in the Baltics have recovered quite well from the COVID-19 restrictions, and the Russian invasion of Ukraine has not yet had a significant impact on consumer spending. Household incomes continue to grow, household savings have risen during COVID-19, and the heating season is now coming to an end, while rising energy prices have been offset by government support measures. At the same time, consumer sentiment has deteriorated markedly since the beginning of February and was only slightly better in April than in the first months of the COVID-19 pandemic. However, consumer spending continues to increase. The lifting of COVID-19 restrictions means more opportunities to consume services, and in April we see a sharp rise in spending on various types of leisure and entertainment services, as well as travel, in payment card data. Consumer spending on goods is also growing, albeit at a slower pace than in the services sector. Inflation in the Baltics is currently outpacing wage growth, and economic uncertainty is high in the second half of the year. Government support measures are expected, but it will probably not be possible to compensate for all the increase in costs, while the savings are not evenly distributed, and some people simply do not have them. The decline in real incomes will mean a need to adjust spending, and retail companies will have to reckon with a decline in the purchasing power of the consumer. In the second half of the year, sales may also decline in certain sectors.

For the Baltic manufacturing COVID-19 pandemic has been successful period and strong external demand has allowed companies to significantly increase production. In March 2022, manufacturing output in Estonia increased by 6.6% compared to March 2021, while growth in Latvia reached 9% and in Lithuania even more than 23%. At the same time, the producer price inflation has reached 30% and it is a big challenge for the industry to find new suppliers of raw materials that were previously purchased from Russia, as well as new markets, as Russia has been an important export market so far. However, external demand remains strong and new industrial orders in the Baltics continue to grow in the second quarter of 2022. Finding new suppliers of metals, chemicals and other raw materials will take time and costs will increase, and the impact from the cutting of economic relations with Russia will be felt more in the second half of the year. Dependence on Russian resources is an important issue not only in the Baltics, but throughout the European Union. Russia's natural gas and oil supplies have so far accounted for about 40% of EU consumption. High energy prices are having a negative impact on the competitiveness and growth potential of European industry, and this is also a risk for producers in the Baltics, as there are signs that high inflation is starting to dampen demand in the world as a whole. New orders in global industry are no longer growing, and the removal of COVID-19 restrictions will mean greater demand in the services sector. Therefore, it is possible that the industry may decline in the second half of the year, and in this situation the risk of sharp fluctuations in raw material prices may pose a risk, as demand may turn out lower than planned.

For the catering, hotel and entertainment industries, the removal COVID-19 restriction will allow to resume operations, and our customers' payment card spending in the service industries has grown significantly since the beginning of the year. At the same time, the war in Ukraine is a new shock to the tourism industry. The number of tourists in the Baltics is still only half the level of 2019, and caution is being exercised after the Russian invasion of Ukraine. Tourism sector is not expected to return to the level of 2019 this year. Also, the breakdown of economic relations with Russia will certainly have a negative impact on the operation of railways and ports, although Latvia saw a slight increase in cargo in March and April. Meanwhile, the IT and business services sector has not been affected by the war in Ukraine and continues to grow rapidly. Exports of IT services in the Baltics have been growing by more than 10-15% annually for 12 years, but rising interest rates are starting to cool the US technology sector, and the number of redundancies in start-ups have been growing since April. At present, there are no signs that the Baltics will be affected, and the long-term prospects for the sector are very positive, but slower growth rates after 12 years of rapid growth are not ruled out.

An active real estate market, stable private sector investment and the inflow of EU economic recovery funds are creating strong demand in the construction sector. However, in construction, as in other sectors, the biggest challenge now is the sharp rise in prices, and in recent months the situation in the building materials market has been exacerbated by the Russian invasion of Ukraine. Therefore, there are signs that the rise in prices and investor caution is revising investment plans and the implementation of some projects is being suspended. However, demand in the construction is strong and the sector is expected to grow in 2022. However, the growth prospects in 2023 are less clear. As COVID-19 has subsided, people have resumed going to restaurants, attending entertainment, traveling and relaxing, but it is becoming increasingly clear that the pandemic has changed the way we work and shop. Remote working and online shopping are here to stay, which means half-empty offices as well as lower demand for retail space. Underused space will be a challenge for entrepreneurs. At the same time, the inflow of EU funds into the Baltic States will continue, but the expected rise in interest rates will make financing more expensive and the time of limitless fiscal deficits is coming to an end. At the same time, however, substantial investment in energy efficiency and renewable energy production is expected in the coming years, and these are new opportunities for growth.

Russia's invasion of Ukraine, high inflation, rising interest rates and falling real incomes are significant risks for the Baltic region. In recent months, growth forecasts for the Baltic economies for 2022 have been reduced, and this year's growth in all three Baltic countries could be around 2%. The good news is that currently the economic situation is still good. Household spending is rising, COVID-19 restrictions have been lifted, households have savings, and rising energy prices are being offset by government support measures. At the same time, unemployment is falling in the labor market, wages are rising and the negative effects of the war on Ukraine are not yet felt. However, the risks of recession in the Baltics in the next year or two are high. Consumer sentiment is pessimistic, prices are rising faster than wages and purchasing power is declining, while the effects of Russia's war are only partially felt. Consumer price inflation in the Baltics is likely to exceed 12% this year, and could be in the range of 4-5% next year. At current energy prices, Baltic energy import costs will increase by substantially. Without public support, households will not be able to cover such costs in the autumn and GDP growth is likely to be very low next year. According to my forecasts, the GDP of the Baltic States will not grow faster by 1-2% next year. The good news is that the Baltic economies are in good shape. Government, household and corporate debt is low, lending is financed by local resources and external trade is balanced. Therefore, the recession is likely to mean lower external demand, a slower recovery in the services sector, lower real incomes and lower purchasing power, and possibly a small rise in unemployment. However, in euro term, the economy will continue to grow, and in this situation it is important not only to think about risks, but also to look for opportunities, and on the part of the government - not to think only about subsidies, but invest in energy sector.