Bank of Estonia : Monetary policy impacts the Estonian economy more than it does in the euro area on average

The latest research by Eesti Pank shows that the monetary policy of the Eurosystem affects growth and inflation in the Estonian economy more than it does in the euro area on average.

In broad terms, monetary policy affects how available and how expensive credit is in the economy. By changing the cost of credit and access to it, central banks can affect the level of economic activity, and through doing this they can control inflation.

The impact of monetary policy is greater in Estonia than in the euro area on average because exports are a larger share of the economy in Estonia than they are in the euro area on average. If it becomes cheaper to borrow, economic activity increases throughout the euro area, and the demand from euro area countries for exports starts to increase, which affects more those countries where exports are a larger share of the economy.

Overall economic growth in Estonia was around 1 percentage point faster in total in 2017 and 2018 and inflation 0.2-0.3 percentage point higher than it would have been without the monetary policy measures . This was the combined effect of interest rates, foreign trade and competitiveness.

The real interest rate, which is the interest rate adjusted for inflation, has been lower in Estonia since 2011 than the euro area average. This is mainly because inflation has been higher in Estonia. This indicates that monetary policy seen through real interest rates has been more supportive in Estonia than in many other countries in the euro area.

Governor of Eesti Pank Madis Müller explained that an appropriate monetary policy creates the right conditions for the long term development of the economy, but a loose monetary policy cannot create sustainable economic growth. 'For each individual economy to function smoothly, it is important for it to be flexible and for its economic policy to be reasonable. When setting the single monetary policy in the Eurosystem, we look at what is appropriate for the euro area as a whole', he said.

The cost of credit affects borrowers directly, and as most loans in Estonia are issued with floating interest rates, changes in monetary policy are generally reflected quickly and strongly in Estonia. Lately, the transmission of the impact has been limited though, because the banks in Estonia have since 2014 issued loans that have a zero floor for the Euribor, meaning that even when the official Euribor rate is negative, the interest rate does not go below zero for the borrower.

Borrowers who took their loans before 2014 have benefited since from negative interest rates. By now however only a small share of loan contracts do not have a zero interest rate floor, and so the interest costs for Estonian companies and households are affected only very little when interest rates move below zero.

Low and negative interest rates have not reduced the savings of Estonian households, but they have increased investment in securities. People have put more and more of their savings into the less regulated or unregulated financial sector in the form of savings and loan associations and crowdfunding.