Prices are rising sharply all over the world, but Latvia is one of the euro area countries that has taken the lead. In May, annual inflation in Latvia was 16.9%. Data for June will be published tomorrow, but no significant changes are expected. What do these figures mean, and what can we expect in the future?
On June 10, the Bank of Latvia (BoL), which is responsible for price stability in the country under Latvian law (this is the BoL's main task), revised its forecast for the main economic indicators, and this estimate projects inflation at 14.8% in 2022, with a downward trend to 7.0% in 2023.
Although the BoL's economic forecasts in Latvia are by far the most authoritative (no other institution in Latvia has such considerable resources), economic forecasting is not much more reliable than meteorological forecasting - in the short term it is still relatively accurate, but in the longer term this reliability falls sharply. That is why these forecasts are regularly revised, and the revisions of June 10 were not unusual.
Two reasons are usually given for the sharp rise in prices. The war in Ukraine and the massive money issuance by the central banks of developed countries during the Covid-19 pandemic. Government and central bankers and economists associated with these bodies emphasize the war in Ukraine, the related sanctions and the disrupted logistics chains, while economists not associated with government and banking bodies cite the injection of huge amounts of cash into the world economy as the main cause of inflation. Between April 2020 and March 2021, financial support for the economy amounted to USD 5 trillion in the US, EUR 2.4 trillion in the euro area and GBP 410 billion in the UK.
Both “theories” have their arguments, although I should point out straight away that I put the word “theory” in quotation marks for a reason, because it is not as if any of the causes of inflation are being denied. It is just a question of emphasis, because neither governments nor national central banks are willing to admit openly that there was "more money than there has ever been" during the pandemic, but now it is time to pay the price for this massive financial "binge".
The proponents of the Russian invasion theory rightly point out that in the last decade both the US Federal Reserve and the European Central Bank carried out several waves of so-called quantitative easing without any inflationary effect. Refinancing rates were close to zero or even negative, and the health of the economy was more threatened by deflation than inflation. That is why the main causes of price rises now have to be found elsewhere than in loose monetary policy.
However, it is difficult for those who emphasize the Ukrainian war to deny that the sharp rise in prices started even before the war. In December 2021, the BoL forecast that the average annual inflation in Latvia would be 6.1% in 2022, which would be much higher than in previous years. Since Latvia is in the euro area and our local capacity to influence the overall inflation trend is small, it is worth looking at this issue on a global scale.
Inflation in the developed world has not been this high since the late 1970s/early 1980s. The main difference between inflation now and then is that in the 1970s the main driver of inflation was the sharp rise in the cost of all goods and services caused by the fifteenfold increase in oil prices.
Now, oil prices are less than twice the 2018-2020 level and not very different from a decade ago (which cannot be said of petrol prices at the pump, which in turn cannot be explained by excise duty increases alone). The cause of the current inflation is therefore the same as the cause of hyperinflation during the collapse of the USSR. Namely, unsatisfied demand. There is more money than there is supply of goods/services. People are willing to pay and are not particularly constrained by the higher prices. I realize that many people may be angered by such a statement, but I am not talking about anyone in particular. I am talking about the average statistical consumer.
Most world economists, including the BoL, expect that this mass of Covid money will gradually be absorbed and prices will gradually stabilize. The BoL forecasts a return to the 2%-3% range in 2024 (official forecast: 2.4%). Similar forecasts are made by the world's leading think tanks, although it must be said that the financial sector is extremely conservative (conformist) and no one there is trying to publicly show their particular, divergent views. If the mainstream view is that inflation will moderate, then this is more or less repeated by everyone. This time, however, there is really no reason to believe otherwise.
A separate and, in my view, very important question is: how should the public perceive these price rises? Two points should be made here. 1) Latvia and other post-Soviet countries still have extremely difficult memories of the devastating inflation of the first half of the 1990s. At that time, inflation completely ate up earlier savings, for many even their life savings and went hand in hand with a very deep economic contraction that pushed large sections of the population into severe poverty.
The situation is now relatively much better. Inflation is high, but it is not catastrophic and, as I said, it is probably on a downward trend. The main consolation, however, is that the economy continues to grow and people's incomes are being indexed. This means that price rises are not pleasant, but they do not and will not lead to a large increase in the number of people in need. Unemployment remains low and employers face strong competition for labor.
2) Latvia and other post-Soviet countries have higher inflation rates than the EU average, partly because overall price levels are still significantly lower here than in "old" Europe. I stress - the overall price level. The fact that some goods or services may be cheaper there than here does not change the point. This levelling out of prices is objective and must be seen with understanding, as a kind of inevitability.
The Covid-19 pandemic and the war in Ukraine have undoubtedly caused serious socio-economic turbulence, of which this outbreak of inflation is a visible consequence. However, the overall economic indicators suggest that these shocks have had less of an effect on people's real living standards than is perceived.
Of course, it doesn’t feel good to pay EUR 100 for the pleasure of filling up your car with petrol, but if people are prepared to pay that kind of money, perhaps it is not so awful after all? One could even say more. Inflation has its pluses. For example, high inflation at low (below inflation) interest rates creates favorable conditions for government debt servicing. For Latvia, these debts are relatively small, but still. Most economists consider deflation to be much more disruptive to the economy. The Great Depression of 1929-1933, with its unstoppable downward spiral of deflation, is forever etched in the world's historical memory.
Moderate inflation (4-6%) is likely to persist for longer than forecast by the BoL and other leading think tanks, but perhaps we should not be so worried about it, as long as incomes are rising faster? Economic contraction, falling incomes, unemployment and out-migration - the parameters that were the key ingredients of the so-called success story of our political class - are much more serious threats that should be feared more.