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Bank of Latvia's forecasts
Economic development
Although the situation on foreign markets started to improve gradually at the end of 2009, plummeting domestic demand remained the main contributor to Latvia's economic development in the second half of 2009. GDP contracted by 17.5% in 2009. The positive trends that emerged in Latvia's economy in the second half of 2009 continued to strengthen also at the beginning of 2010. The forecast for 2010 remained unchanged, with the GDP decrease amounting to 2.5%.
The degree of uncertainty surrounding the GDP forecasts remains high. Downside and upside risks remain broadly balanced (see Chart 1). In addition to the still persisting upside risks (i.e. potentially higher export growth and faster economic stabilisation), a short-term rise of private consumption may be supported by the ruling of the Constitutional Court of the Republic of Latvia concerning old-age pensions and the related additional budgetary expenditure to ensure disbursements of the old-age pensions. Yet already next year, with the government implementing additional consolidation measures and offsetting this extra spending by expenditure cuts in other areas, this decision will reinforce the downside risks.
Chart 1. GDP changes
(annual percentage changes; Bank of Latvia forecast*)
* The coloured area represents 90% of potential scenarios (the
lighter the colour, the lower the scenario's probability).
The growth of the downside risks is related to the negative economic development trends observed in Greece and Spain, as they may slow down the recovery of the euro area economy. Economic risks relating to high unemployment, falling household incomes, low lending, potential future raise of the key ECB rates and other budget deficit curbing measures persist.
Looking at the potential overhangs in the business cycle and trying to estimate the exact period of their occurrence, one has to bear in mind that the seasonal adjustment method provides that when a new observation becomes available the whole previous time series are adjusted accordingly. Consequently, overhangs are often detected with a delay. Latvia is not unique in this respect: most other countries identified the recession in their official statistics with a delay of about half a year, after revising the previous data. Identification of a trough in the economy could have similar delays. According to the latest official statistics, the lowest point could be reached in the second quarter of 2010. Yet maybe already at the turn of the year it will be quite justified to conclude that it was reached already in the first quarter of 2010 or even the fourth quarter of 2009. Overall, the Bank of Latvia estimates that the economic downturn of the preceding years most likely was not as deep as suggested by the data published by the CSB.
Inflation
The subdued domestic demand is expected to continue to push down the level of prices in the nearest future and, with the economic activity remaining sluggish, overall prices will continue to decline throughout 2010. Consumer prices are expected to decrease by an average of 3.8% in 2010. Over the medium-term, risks to the inflation outlook seem broadly balanced (see Chart 2).
Chart 2. CPI changes
(annual percentage changes; the Bank of Latvia forecast*)
* The coloured area represents 90% of potential scenarios (the
lighter the colour, the lower the scenario's probability).
Downside risks are primarily related to shrinking household incomes and high unemployment having further adverse effect on domestic demand. On the supply side, labour productivity improvement in combination with contracting real wage and salary will continue to compress the unit labour costs, thereby maintaining a downward pressure on prices.
Potential expansion of the grey economy poses upside risks; therefore, the actual fall in household income may be smaller than that suggested by the official statistical data. Additional upside risks relate to the global energy price developments. With the global economic activity recovering, the prices may grow significantly. Moreover, the share of energy prices in Latvia's basket of consumer goods has expanded significantly year-on-year in 2010, thereby strengthening the impact of energy price movements on the overall price index.
