Latvijas Banka actively monitors developments in the euro area economy to take an active part in the Eurosystem's monetary policy workflows and decision making. In 2021, monetary policy decisions of the ECB continued to provide significant support to the euro area economy to overcome the crisis.

In 2021, the euro area economy rapidly recovered, but it was not "out of the woods" yet.

Fast and efficient response by governments and central banks to the economic crisis caused by the Covid-19 pandemic allowed the euro area and Latvian economy to recover faster than expected in 2021. According to the December 2020 Eurosystem staff projections, the euro area economy would recover to the pre-crisis level seen in the fourth quarter of 2019 only by the middle of 2022. In 2021, however, the recovery was stronger than anticipated at 5.3% and so the GDP reached the 2019 levels already by the end of the year.

Chart 1
GDP, forecasts by the ECB and Covid-19 confirmed cases and death rates in the euro area (Q4 2019 = 100)

One of the main drivers of growth was private consumption that recovered faster than expected even during the spread of new Covid-19 variants. These developments were a result of several factors. First, the generous monetary and fiscal policy support protected the economy from a rapid loss of jobs and a decrease in people's earnings. Second, vaccination made it possible to ease mobility restricting measures. Moreover, in comparison to 2020, the economic activity also improved due to better ability of households and businesses to adjust to pandemic restrictions.

The rapid recovery of demand combined with supply restrictions stimulated inflation also in the euro area. From 0.3% in 2020 it increased to 2.6% in 2021, and year-on-year it grew from 0.5% in January to 5% in December (see Chart 2).

Chart 2
Inflation and its components in the euro area (annual changes; %)

Monetary policy response seeks the balance between short-term economic support and long-term stability.

However, the upswing in business cycle observed in the euro area was much slower than in the US and the UK where the central banks started an active discussion on discontinuing monetary stimulus already at the end of 2021. Labour market indicators also demonstrated that employment levels and the number of economically active population in the economy were lower than before the pandemic, while the wage growth remained moderate. Thus, the Governing Council of the ECB considered the growing price pressures to be driven primarily by temporary factors and did not hurry to withdraw monetary policy stimuli. Premature discontinuation of monetary support when the monetary policy is restricted by the lower bound of interest rates and the economy has not sufficiently recovered after the crisis may again result in lower growth and excessively low inflation risks.

Chart 3
Labour market (Q4 2019 = 100)

During this period of high uncertainty, to signal the readiness of the central bank to act depending on the economic developments, the ECB decided that purchasing of securities under the PEPP will be flexible. Purchasing of assets under the PEPP significantly increased during the second and third quarters and became less active at the end of the year when the economy started to recover. At the end of the year, the Governing Council of the ECB also decided that net asset purchases under the PEPP will run at a slower pace at the beginning of 2022 and will be discontinued at the end of March. At the same time, the period of reinvestment of principal under the PEPP was extended to the end of 2024. To manage moderate PEPP discontinuation and avoid unnecessary stress in the financial markets, it was decided that APP net monthly purchases should be increased in the short term to gradually move towards discontinuation of APP net purchases.

As a result of the accommodative monetary policy, historically low interest rates persisted.

Overall, during the last two years asset purchases and TLTRO (see Charts 4 and 5) were material in strengthening the economy. The Eurosystem extended the most favoured interest rate period applicable to TLTRO until June 2022. However, the amount of TLTRO allotted in Latvia in 2021 decreased, as voluntary early repayments of funds borrowed via TLTRO were made.

Chart 4
Balance of the Eurosystem's monetary policy securities portfolio (billions of euro)

Chart 5
Outstanding amount of the Eurosystem's longer-term refinancing operations (billions of euro)

Continuing sizeable asset purchases and favourable lending conditions for credit institutions during TLTRO auctions maintained the money market interest rates close to the ECB interest rate on the deposit facility set by the Governing Council (see Chart 6). It also allowed for maintaining low sovereign and credit institution borrowing costs that contributed to continuation of historically low credit interest rates ensuring faster recovery of the economic activity in the euro area (see Chart 7).

Chart 6
ECB's deposit facility rate and the euro area short-term rate EONIA and €STR (%)

Chart 7
Financing conditions in the euro area (%)

Overall, Latvijas Banka is of the opinion that the current monetary policy support to the euro area economy has been adequate to ensure that the inflation target is reached in the medium term. As upward risks materialised and the inflation remained high for a longer period of time than initially expected, and as the euro area economy continued to recover, the monetary policy stance required adequate adjustments.

Monetary policy transmission in Latvia was hindered by the conservative lending policy of credit institutions.

Interest rates on loans to businesses in Latvia remained among the highest in the euro area in 2021. It can be explained not only by a higher credit risk of companies or higher credit institution financing costs in Latvia versus the euro area but also by a higher financial market concentration and more prudent credit institutionsA
. However, the very favourable monetary policy conditions made it possible to slightly cut lending costs in Latvia in 2021. This process was also affected by the participation of some Latvian credit institutions in TLTRO, as well as by the activity in the securities market and the additional competition it created for the credit institution sector. Unfortunately, fragmented participation of Latvian credit institutions in TLTRO auctions also resulted in customer financing cost differences. Latvian credit institutions that participated in the TLTRO indeed reduced the offered corporate interest rates in 2021, while the trend was not visible in other credit institutions.

In parallel to the regular monetary policy developments, greater attention was also given to monetary policy strategy and sustainability issues.

2021 was important for the ECB and Latvijas Banka not only in the context of the monetary policy decisions but also due to the thorough review and presentation of the new ECB strategy. Latvijas Banka actively engaged in these activities (see the section Research). It was a historic event for the single monetary policy of the euro area as the previous revision of the euro area monetary policy target took place in 2003.

The reviewed strategy has a symmetric 2% inflation target in the medium term (before – "below, but close to 2%"). This means that both positive and negative deviations from this target are equally undesirable. Moreover, this strategy provides for a very focussed or longer monetary policy action in cases when the economy operates close to the lower bound of interest rates to prevent persistent downward deviations of inflation from the target. It may also include a transition period during which inflation is slightly higher than the target. These changes will support more efficient implementation of monetary policy and take into account a range of fundamental changes in economic conditions since the previous review of the monetary policy strategy.

In addition to the new inflation target, the approach to measuring inflation was also clarified. According to the Governing Council of the ECB, the Harmonised Index of Consumer Prices (HICP) should strive to better reflect inflation faced by most people on daily basis. Thus, it was decided that the HICP will continue to serve as a measure of inflation; however, in the future it will be supplemented by owner occupied housing prices.

For communication on monetary policy to be more efficient and increase public awareness and trust in the central bank, during the strategy review the ECB decided to make it more understandable to a wider range of people, and undertook to regularly organise public hearing events.

To support the European Union policy towards climate neutral economy by 2050, the new monetary policy strategy includes a published climate change action plan. It stipulates how the ECB will include climate change considerations in the monetary policy framework in the nearest future. The ECB categorises climate change risks into two large groups: adaptation risks that are related to potential losses caused by extreme natural events, and transition risks that are related to economic challenges to move from the current economic model to a more sustainable low carbon model. Climate change considerations will also be taken into account during the development of economic analysis, modelling and forecasting tools, as well as during the implementation of monetary policy. These measures will help governments, companies and households contribute to the economic transition to climate neutral and sustainable activity.