Markets are now expecting faster price increases and the accompanying rise in interest rates as a result of the energy crisis. Faster inflation, the resulting slower growth in purchasing power and heightened uncertainty linked to the energy crisis will together lower Estonia's economic growth forecast for this year to 2.8 percent, the central bank said on Tuesday.

"Because developments in the energy market affect the economy and are at the same time unpredictable due to geopolitical reasons, it is likely that actual economic performance will differ from this forecast in terms of both prices and economic growth," the agency added.

"The growth environment for the Estonian economy continued to improve at the start of the year. The impact of the new energy crisis has not yet been reflected in statistics describing economic activity, but various indicators confirm that before the outbreak of the Middle East conflict, Estonia's economy was clearly on a recovery path," the central bank noted.

According to the Bank of Estonia, this year's economic growth will therefore be driven by domestic demand, as both consumption spending and investment are increasing. The fastest growth will come from government defense-related investments, most of which consist of imported goods. As a result, the money spent on these flows out of Estonia and does not directly contribute to economic growth. However, changes to the Income Tax Act will have a strong impact on people's purchasing power and ability to consume.

The average gross monthly wage will rise by about 6 percent this year, while the average net wage will increase significantly more — by around 10 percent — due to a reduction in the effective tax rate.

"This means that even taking price increases into account, real income will grow significantly, which in turn will boost consumption and the economy as a whole," the Bank of Estonia said.

Energy prices, which have risen during the Middle East war, and their indirect effects will keep inflation higher than it otherwise would have been. "Compared with the 2022 energy crisis and the price surge at that time, the pass-through of rising oil prices to gas and electricity prices has been more modest in European countries due to diversified suppliers, as confirmed by available data. This reduces the overall impact of higher oil prices on the consumer basket," the central bank added.

"Futures transactions in the oil market at the time the forecast was compiled indicated that markets expect oil prices to start declining in the second half of the year. If this assumption holds, inflation in Estonia would reach around 3.8 percent in 2026 and slightly above 2 percent in the following two years," the forecast states.

The budget deficit and public debt will increase, raising the government's annual interest payments.

"The growth in defense spending and the reduction in revenues resulting from changes to the Income Tax Act are the main factors that will increase the general government budget deficit to 4.4 percent of GDP this year," the Bank of Estonia said.

"If the government and the Riigikogu do not change course, the deficit will remain at a similar level over the next two years. Although Estonia's public debt remains low in international comparison, the continued rapid growth of debt is a concern. Given Estonia's long-term security outlook, demographic situation and rising interest costs, serious consideration should be given to how to return public finances to a sustainable path and curb the growth of the debt burden," the central bank noted.

"In the case of a large and persistent budget deficit, new decisions should bring the budget closer to balance, not further away. Tax policy decisions should be well-considered, clearly explained in advance, durable and supportive of economic growth," the central bank added.

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