Sound position going into first quarter, but Russian military aggression poses risk to economic activity, inflation risk in particular

The economy remained sound in the first quarter of this year in Slovenia and in the euro area overall, albeit not reaching the heights of growth seen last year. The Russian military aggression that began in February and the sanctions imposed in response have worsened the economic outlook, most notably sharply increasing the risk of a long period of elevated inflation. It has also been reflected on the financial markets, where volatility has increased sharply and liquidity has declined. Banka Slovenije should reiterate that the labour market in Slovenia remains extremely buoyant.

After last year’s high growth, developments in the euro area economy have remained relatively favourable this year. According to the latest projections drawn up under the aegis of the ECB, economic growth is forecast at 3.7% this year (or 2.3% under the adverse scenario), which is above its long-term average. The high rates of economic growth began to slow slightly at the end of last year amid the introduction of more stringent containment measures and the disruptions to supply chains. The Russian military aggression that began in February depressed the economic outlook and increased uncertainty, which was reflected in March’s downturn in the assessments of future demand by manufacturing and retail firms.

The outbreak of the Russian military aggression in February brought a sharp increase in the risk of a longer period of high inflation. The rate passed 2.0% in July of last year, and reached 7.5% in March of this year. Inflationary pressures are also being raised by the current situation on international markets for energy, commodities and food. According to the projections drawn up by the ECB, inflation is forecast to average 5.1% this year (or more than 7.0% under the adverse scenario). The high inflation is already affecting purchasing power: average wage growth in the euro area was negative in real terms in the final quarter of last year.

The financial markets showed a sharp increase in volatility and a decline in liquidity in the first quarter of this year, particularly in more speculative assets. The Russian military aggression drove investors to lower-risk investments, which was reflected in a rise in safe-haven currencies and gold, while equities and higher-risk bonds fell sharply in price. The forecasts of higher, more sustained inflation pushed a number of global central banks into signalling the faster normalisation of monetary policy.

Slovenia too saw the economy continue to perform well in the early part of this year, following last year’s extremely high economic growth (8.1%). Banka Slovenije’s nowcasts suggest quarterly GDP growth averaged 1.0% in the first quarter of this year, despite the decline in confidence caused by the Russian military aggression. For now the loss of confidence is affecting manufacturing and consumers, and most firms have already reduced their assessments of future demand.

Inflation in Slovenia stood at a high 6.0% in March, and according to our rough estimates would have been more than 2 percentage points higher in the absence of the government measures to mitigate the impact of surging energy prices. High energy prices are increasingly passing through into prices of other goods, while a rising share of goods and services are seeing high inflation. Consumer inflation expectations in March were their highest to date.

The situation on the labour market remains highly favourable. Employment is continuing to rise, while registered unemployment according to the seasonally adjusted figures is now lower than its previous low of 2008. Given that employment expectations at firms remain high, while the availability of workers on the domestic labour market continues to decline, the hiring of foreign workers is still increasing.

The average nominal gross wage was down 2.7% in year-on-year terms in January, while the real gross wage bill was down 1.7%. In both cases the main driver is the normalisation of wage levels in public services after the expiry of most pandemic-related wage bonuses. Amid the ongoing rise in employment and wages, real growth in the wage bill in the private sector remained high at 5.6%, despite the high inflation.

In the strong economy the government’s fiscal position improved last year and in early part of this year, although risks to the public finances are increasing as a result of the application of several permanent discretionary measures (e.g. in connection with personal income tax, extraordinary pension increases, changes to sick pay), the Russian military aggression, and the situation on energy markets.

Figure: Contributions to inflation

Sources: ECB, Eurostat, Banka Slovenije calculations

Publication Semi-annual overview of economic and financial developments, April 2022 is available on the link.