Forecasts of Latvijas Banka

20.06.2014.

Economic developments

Manufacturing, energy and agriculture (due to the unfavourable weather conditions) most probably were those sectors that contributed negatively to the overall GDP growth at the beginning of the year; however, a considerable increase in output in the construction sector offset the above. Nevertheless, the domestic factors had become less significant in early 2014. Situation in the global economy and in Europe is approximately in line with the forecasts, i.e. gradual recovery of growth persists, but risks associated with the escalation of the regional geopolitical situation, having a very high degree of uncertainty, have strengthened. Hence, the degree of uncertainty of the economic outlook rose considerably at the end of the second quarter of 2014. As a result, development forecasts for several sectors (particularly for manufacturing, transportation and storage, travel, etc.) largely depend on the future geopolitical developments. 

In view of the preliminary sectoral data for the first quarter (according to the flash estimate, real GDP posted 0.7% quarter-on-quarter growth in the first quarter) and the aggravation of the geopolitical situation, the real GDP forecast for 2014 by Latvijas Banka is reduced to 3.3%. This forecast is based on assumptions related to a decline in Russian external demand, the effect of the depreciation of the Russian ruble, negative confidence effects resulting in potentially weaker than forecast investment dynamics, as well as lower household spending due to a potential increase in precautionary savings. The basis forecast does not comprise further escalation of the geopolitical situation or introduction of any further sanctions.

Overall, risks to the national economic growth outlook can be considered balanced in the medium-term. Further escalation of the geopolitical situation may create additional negative effect on the Latvian economy by weakening the demand of the Russian and Ukrainian economies for imports, inter alia those exported from Latvia. The escalation of the situation would also create negative confidence effects by moderating investment activity as well as weakening private consumption on account of household precautionary savings growth. Moreover, any further introduction of specific sanctions (in any direction) is likely to have a negative effect on the Latvian economy. At the same time, the positive risks should not be underestimated. With the geopolitical situation improving or at least stabilising, the above negative factors could be merely a short-term phenomenon, thus having a less negative impact on the economy than assumed in the baseline scenario. Also, judging by the investment projects announced in mass media and by the impact of the allocation of EU structural funds (it applies more to public investment which is less exposed to negative confidence effects) investment may grow at a more accelerated pace than forecast. The manufacturing industry has also proved already before that it is capable of transforming relatively quickly, finding new markets, as well as expanding its market shares also under declining external demand (for the forecast of GDP changes, see Chart 1). 

Chart 1. GDP changes (year-on-year; %; forecast of Latvijas Banka*)

GDP changes (year-on-year; %; forecast of Latvijas Banka)

* The coloured area represents 90% of potential scenarios (the lighter the colour, the lower the scenario's probability).

 

Inflation

The annual inflation rate has become positive and closer to the levels characterising economic growth. Nevertheless, the annual inflation rate remained low on account of the supply side factors of the reference period as well as heterogeneous effects of seasonal factors. Uncertainty of the impact of global commodity prices has risen, while inflation expectations have decreased considerably.

The forecast of the average annual inflation for 2014 is revised downwards to 1.1%, and its risks are considered balanced. The above is also in line with the revised growth forecast (for the forecast of SPCI changes, see Chart 2). The postponement of electricity market liberalisation for households until 2015 is the major factor having a downward effect on inflation. Slower economic growth and a more moderate rise in actual food prices could limit the increase in annual core inflation.

Although the first estimates of the harvest of this season were quite pessimistic due to the draught in the US and black frost in Europe, it is still too early to assess the actual impact of the above factors. Risks related to the impact of political factors are on the upside (mostly as a result of energy and food trade); at the same time, however, they are also surrounded by a significant degree of uncertainty.

Chart 2. HICP changes (year-on-year; %; forecast of Latvijas Banka*)

HICP changes (year-on-year; %; forecast of Latvijas Banka*)

* The coloured area represents 90% of potential scenarios (the lighter the colour, the lower the scenario's probability).


Source: Macroeconomic Developments Report. June 2014

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