Successfully brining down inflation will be the most important challenge for the economy in 2022

The economic recovery in the Baltics has been significantly faster than in other European countries, and less than two years after the start of the pandemic, all three Baltic States have exceeded previous GDP levels. Latvia's GDP in the third quarter of 2021 was 1.7% higher than in the fourth quarter of 2019, while Lithuania and Estonia's GDP is now respectively 4% and 5.1% higher than at the end of 2019. Meanwhile, GDP in the euro area as a whole is still 0.3% lower than before the COVID-19 pandemic. Interestingly, the economic growth of the Baltic States in 2021 will be even fastere than forecasted in September 2020, before the second and third waves of the pandemic. In my opinion, this shows both the flexibility and ability of entrepreneurs to adapt to the new situation and the importance of state support to the economy. However, the economic recovery is uneven and large-scale global economic support measures are increasingly contributing to rising prices. In my opinion, successfully curbing inflation will be the most important issue for the economy in 2022. Therefore, the third year of the COVID-19 pandemic will be different from the first two years, but there is no reason to believe that the economy will not continue to grow.

Business sentiment in the world's leading economies is strong, world trade and new industrial orders are growing, and unemployment in the US and Europe is approaching pre-crisis levels. Economists surveyed by Bloomberg predict that the US economy will be larger in 2023 than forecasted before the COVID-19 pandemic, while the eurozone economy will return to its previous growth trajectory. Such a rapid economic recovery after such a severe economic downturn would be a unique event in the history of the world economy. However, the challenges in the global economy are definitely increasing. The rapid rise in inflation, the energy crisis in Europe, growth slowdown China and turmoil in the Chinese real estate sector, as well as geopolitical tensions and the rapid spread of the COVID-19 omicron variant, are significant risks that will affect both the global economy and the Baltics in 2022. The good news, of course, is that existing COVID-19 vaccines still prevent serious illness. But vaccines are not perfect and countries are being forced to impose new restrictions, and China's attempts to stop the virus completely in its country could lead to new supply chain disruptions. Limited production and sustained demand are likely to mean that future waves of COVID-19 will boost rather than slow global price rises.

After a long period of low inflation since the 2008 global financial crisis, the pace and the persistence of inflation was certainly one of the biggest surprises for economists and central banks in 2021. Large budget deficits, record low central bank interest rates and rising money supply have contributed to a rapid but uneven global economic recovery. Limited access to services has significantly increased consumption of goods, leading to rising global prices for a wide range of resources, industrial inputs and transport services. Historically, rising resource prices alone do not usually lead to a sustained increase in inflation rates, and with some exceptions, global natural resource prices are currently only slightly above their 2011 highs. However, initial expectations of a rapid decline in inflation have not materialized and the sharp rise in the prices of resources such as fertilizers is already creating the conditions for further increases in consumer prices in 2022.

The uneven and rapid economic recovery, the strong support measures for the economy and the coincidence of political and climatic factors since the summer of 2021 have led to a very sharp rise in energy prices in Europe. Compared to previous years, electricity market prices in Europe have increased 3-5 times and natural gas prices in oil equivalent have reached 150-200 US dollars per barrel. Natural gas reserves in Europe are significantly lower this year than in other years, energy demand is relatively inelastic and there are several more months before the end of winter, during which supplies could fall to record lows. The sharp rise in energy prices this year is also seen in Asia, which has increased competition for liquefied natural gas cargoes. At the same time, local natural gas production in Europe declined in 2021 and the climatic conditions in Europe have not been favourable for renewable energy production over the last year. Russia is also likely to use this situation to achieve its political goals on Nodrstream 2 certification and Ukraine, as natural gas supplies from Russia have also fallen in Europe in 2021. Warmer weather in early January and liquefied natural gas supplies from the United States have led to lower natural gas prices in Europe, and the situation is expected to improve after the end of the winter. However, natural gas futures prices for the summer and autumn of 2022 are still about 3 times higher than in recent years. Meanwhile, as part of the European Green deal, a number of countries are closing down nuclear power plants and abandoning coal, which will mean greater dependence on natural gas in the future. Therefore, in the future, we are likely to face higher and more volatile energy prices in Europe as a whole.

Global inflation is currently driven by cyclical factors, but declining unemployment, rising wages, deglobalisation and the changes required to meet climate targets are rather structural factors. And the longer inflation remains high, the greater the risk that it will become permanent. Developed countries will face a major challenge in 2022 to curb inflation without jeopardizing economic recovery. According to the financial market expectation, the US could raise interest rates 3-4 times in 2022 and even the ECB could start cutting negative rates. At the same time, debt levels have risen during the COVID-19 pandemic and rising interest rates would increase debt service costs. Therefore, the first signs of a possible slowdown in economic growth have also emerged in the financial markets. Reducing economic support measures, together with the normalization of consumer demand, could also mean slower growth in world trade. Therefore, in my opinion, the outlook for the economy in the second half of 2022 could become much more cautious than it is today.

Global demand for goods remains strong, inventory levels are relatively low in many sectors, and production and supply chains remain highly congested. Until now, the Baltic producers have been able to successfully take advantage of the growing external demand, and in my opinion, the industry is expected to grow quite strongly in the first half of 2022 as well. At the same time, there are currently no reasons why service sectors that are not directly affected by COVID-19, such as IT, professional and business services, should not continue to grow in 2022. The EU's economic recovery will start to flow into construction in 2022, and there is considerable potential for recovery in various service sectors, which are still affected by COVID-19 restrictions. Meanwhile, inflation is likely to peak in the first months of 2022 and slower consumer price inflation in the second half of the year will ease negative pressures on consumers. Therefore, according to my current forecasts, the GDP of the Baltic States could grow by 3.5-5% in 2022.

Inflation in the Baltics has now reached its highest level since 2008-2009 and is the fastest in the European Union. In Lithuania and Estonia, the rise in consumer prices has exceeded 10%, while in Latvia at the beginning of 2022 inflation could be close to 10%. The share of energy and food in consumption in the Baltic States is high and we are therefore more sensitive to global price fluctuations. At present, more than half of inflation in the Baltics is driven by rising fuel, electricity, natural gas and heat prices. There are many causes for the energy crisis in Europe, but current record price levels are likely to be at least partially transient. Therefore, inflation in the Baltics will decrease at the end of 2022. But inflation has become broader in recent months and therefore the normalization of energy prices will not stop the general rise in prices. At least not right away. At present, producer price inflation in the Baltics has exceeded 20% and the pressure to pass on price increases to consumers is high. The rise in energy prices has not yet been fully reflected in final consumer prices, and entrepreneurs have to reckon with a sufficiently rapid rise in wages, as the working age population continues to decline and wage growth has long outpaced productivity growth. This will make entrepreneurs think more and more about raising prices. And this is relatively easy at the moment, because both consumers and businesses know that inflation is rising and the reasons for the rise in prices do not need to be explained.

In 2021, the manufacturing industry in the Baltics will grow significantly faster than the economy as a whole. In Latvia and Estonia, production volumes in the first 10 months of 2021 have grown by 6-8%, while in Lithuania the growth of the manufacturing output has reached 18%. Manufacturing ouput in all three Baltic countries and in most industries are well above end-2019 levels, which has been one of the reasons why the Baltic economies have been able to recover so quickly from the initial COVID-19 shock. Industrial sentiment is positive and export orders are growing, therefore the Baltic manufacturing is likely to have a year of good growth this year. However, in recent months, industrial prices have been rising significantly faster than manufacturing output, and the European energy crisis is also a significant risk for Baltic industry. The good news is that so far the rise in electricity prices has not had a significant impact on industry and electricity consumption in the Baltics continues to grow. For companies with fixed tariffs, electricity prices have not risen as fast as market indices, and energy costs for producers in the Baltics generally do not exceed 4-7% of turnover.

An active real estate market and rising real estate prices, investments by EU economic recovery funds, a gradual increase in lending and an increase in investment in industry suggest that 2022 will be a good year for construction in the Baltics. In addition, Latvia will hold the Saeima elections in 2022 and the election years are usually good in construction. I think that this year will not be an exception and in the Latvian state budget for 2022 investment expenditure is planned to increase by 25%. It is possible that the implementation of some EU fund projects may be delayed, but in 2022 the state will definitely invest more in construction than in 2021. The biggest challenge in construction, like in manufacturing, is likely to be rising prices. There is not much spare capacity in the construction sector and in the 3rd quarter of 2021 the prices of construction materials in the Baltics increased by 12-17% compared to 2020. The rise in energy resources is likely to mean a further rise in building material prices in 2022, so some projects in the private and public sectors may be delayed or cancelled.

Unemployment in the Baltics increased during the COVID-19 pandemic, but in November 2022 unemployment in Estonia fell to 5%, while in Latvia and Lithuania it was 7.3% and 6.0%, respectively. Meanwhile, the average salary in the Baltics in the first three quarters of 2021 has grown by 6.7% in Estonia and by more than 10% in Lithuania and Latvia. The decline in employment in the service sectors affected by the COVID-19 crisis has reduced the number of low-wage earners and arithmetically increased the average wage, but our customer data confirm a significant increase in income in 2021. As a result, more and more companies are reporting difficulties in finding employees. At the same time, distance learning and various other reasons have led to a decline in the economically active population, a further decline in the working age population due to demographic factors and a decline in other sources of labour, such as foreign students, who are currently able to study remotely. In the near future, labour shortages are most likely to be felt in the service sectors, as workers have left for other sectors that have grown during the COVID-19 pandemic. Taking into account the inflation forecast for next year, economic growth and the unemployment rate, the growth of the average wage in 2022 could exceed 7-8%.

Rising personal incomes and limited access to services have boosted retail sales in the Baltics. In the first eleven months of 2021, the total retail trade turnover at constant prices in Lithuania and Estonia has grown by more than 10% compared to 2020, but in Latvia the retail trade growth was only 1.8%. Over the last 10 years, the development of retail trade in all the Baltic States has been almost identical, but this year retail trade in Latvia has grown significantly more slowly than in Lithuania and Estonia. The economic growth of Lithuania and Estonia in 2021 has been slightly better than in Latvia, and consumption in Estonia has been boosted by the possibility for people to withdraw their 2nd pillar pension savings. However, wage growth in the Baltics is similar and household deposits in the Baltic States have increased by 16-21% in 2021. Therefore, the differences in retail trade between the Baltic States are mainly due to epidemiological restrictions on trade, which in Latvia have been more widespread than in Lithuania or Estonia.

Compared to many other European countries, the Baltic States have been very successful in overcoming the COVID-19 pandemic. GDP in all three Baltic countries has already exceeded pre-pandemic levels, and Lithuania and Estonia have been among the leaders in growth in Europe for the past two years. Meanwhile, Latvia's economic recovery has been slightly slower. This difference is most likely related to both economic factors and wider and longer-lasting COVID-19 related restrictions in Latvia. This affects both trade and tourism, where we have been weaker in the second half of 2021 than in Lithuania and Estonia. Lithuania and Estonia have also had their success stories in recent years, such as the Pfizer COVID-19 vaccine plant in Lithuania and the Volkswagen Group's investments in Estonia. Latvia, on the other hand, has failed to find its niche after losing Russian commodity transit cargoes and associated servicing of non-resident financial flows. However, the relatively slower growth in sectors where there is no objective reason to lag behind neighbours, such as exports of IT services, is a major concern. This suggests that it will difficult for Latvia to catch neighbours in the near future.

During the COVID-19 pandemic, the Baltic economies performed better than expected, but 2022 could be different. Since mid-2021 the economic growth forecasts for the Baltic States for 2022 have been reduced several times, while inflation continues to rise faster than expected. And the risks to the economy are increasing. Rising inflation and the energy crisis in Europe are having a negative impact on both consumers and businesses, and natural gas futures prices for the second half of 2022 are currently about 3 times higher than in recent years. This means that energy prices in the Baltics may continue to rise in the second half of the year. According to my forecasts, if current price levels are maintained in the long run, the GDP growth of the Baltic States in the coming years could be 2-4 percentage points lower than currently forecast. And the external environment may also become less favourable in 2022. Inflation is not only an economic problem but also a political one, which may mean less support for the economies. The US will raise interest rates this year, the global debt burden is high and the financial markets are already starting to signal a slowdown in the global economy. The budget deficits will also have to be reduced in the Baltics, and in Latvia, after the forthcoming Saeima elections in the autumn, the room for manoeuvre in the budget will most likely be very small. In global industry, such strong demand for goods is unlikely to be sustainable, while differences between Lithuania and China have the potential to negatively affect industry in Lithuania. Therefore, in my opinion, there may be unpleasant surprises in the economy in the second half of 2022.