Tallinn's Linnahall, originally known also as the V. I. Lenin Palace of Culture and Sports, was completed for the Moscow 1980 Summer Olympics. It is situated in the harbor, just beyond the walls of the Old Town in Tallinn, Estonia. (Juho Kuva for The Washington Post)

Rate hikes are little help for Estonia’s 22% inflation, Europe’s worst

Some employers give raises three times a year while others desperately try to cut energy costs

TALLINN, Estonia — In the two years since developer AS Kapitel drew up plans for a flashy new office complex here, the price of just about everything needed to complete it has gone up.

Steel grew more expensive as Russia’s invasion of Ukraine interrupted shipments from mills in both countries. Glass panels for the buildings’ exteriors cost more because the natural gas used to produce them has soared in price. And wages have jumped as an overheating local economy collided with a worker shortage.

All together, inflation has added about $30 million to the cost of the Arter Quarter complex, which is set to spruce up a nondescript city center street with a new town square, public park, sports club, sauna and multiple restaurants. Amid talk that Europe could slide into recession following the European Central Bank’s decision last month to raise interest rates, Kapitel executives fear they will be unable to recoup their ballooning costs from tenants, putting at risk the company’s profit hopes.

“All the raw materials went up and not just because of the war. It started last autumn,” said Rait Pallo, Kapitel’s chief financial officer. “These things were pretty scary for us.”

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Estonia is suffering the worst inflation in the euro area, with consumer prices rising at an annual rate of nearly 22 percent — more than twice as fast as in the United States. This tiny Baltic nation, and its neighbors, Latvia and Lithuania, represent extreme examples of the price pressures sweeping Europe and confronting policymakers, executives and consumers with a challenge unseen for 40 years.

Some Estonian employers must raise salaries several times each year. Others are retooling their operations to use less energy. Consumer grumbling about rising prices, meanwhile, is muted, overshadowed by existential worries about the threat from neighboring Russia.

“Of course, it’s annoying. But it’s happening globally; it’s not only our problem here in Estonia,” said Marju Vanatalu, a shopper at the Viru Keskus mall. “But the most important topic for Estonians is the war in Ukraine. This is more important than inflation.”

The two subjects are related. Russia’s invasion of Ukraine upended global commodity markets, sending prices rocketing for oil, natural gas, wheat and fertilizer.

Higher energy costs account for about one-half of Estonia’s inflation and rising food prices account for an additional one-quarter, according to the central bank.

Since Estonians remain poorer than the European Union average, food and energy take up a larger share of the typical consumer’s spending than in countries such as Germany or France, helping to explain why inflation is so much higher here.

“Some prices are two times or five times higher,” complained Vladislav Vassiljev, another shopper and an aspiring science-fiction writer. “Especially for utilities and gas for the car.”

Filling up a Toyota Camry, for example, now costs the equivalent of about $130, up from about $86 one year ago, based on average pump prices.

But even excluding volatile energy and food costs, prices are rising fast.

Consumers emerged from the depths of the pandemic with ample savings, fueled by years of steady wage growth. Then last fall, the government began allowing withdrawals from a mandatory retirement savings program, which further stimulated consumption.

“You could see it in electronics stores. People were buying TVs and home appliances,” said economist Kristo Aab of LHV Bank, who estimates Estonians withdrew roughly 1 billion euros.

All that extra demand — at a time when the supply of some goods was constrained by shipping problems or component shortages — drove prices higher. Housing prices and rent also rose sharply, prompting many workers to appeal for higher pay.

At Cybernetica, which develops software for government and corporate clients in 35 countries, CEO Oliver Vaartnou is in a nonstop scramble for talent.

“I used to change salaries once a year. Now, I’m doing it two times a year, maybe three times,” Vaartnou said. “I need to keep these people. If I don’t have software engineers, I don’t have anything. I’m willing to take the risk I won’t be profitable this year.”

Estonia surrendered control over its monetary policy in 2011, when it joined the European currency union, becoming the first ex-Soviet republic to do so. After decades of rule from Moscow, Estonians saw the change as a price worth paying to cement the country’s place in Europe.

Euro-using countries share a common central bank, just as U.S. states have the Federal Reserve. But each nation retains its own tax and spending authority. So the financial transfers between rich and poor areas, which smooth out economic ups and downs, are more limited.

Embracing the euro left Estonia subject to interest rates set by the Frankfurt-based ECB, which prioritizes the needs of the euro zone’s largest economies, such as Germany. Inflation there is roughly one-third of Estonia’s level.

The ECB’s half-percentage-point increase last month brought its main policy rate to 0 percent, after years in negative territory. But Estonia’s current situation warrants an interest rate around 7 percent, according to a recent assessment by the Organization for Economic Cooperation and Development (OECD) in Paris, which cited a widely used monetary policy guideline.

“Interest rates are too low to tame Estonia’s high inflation,” the OECD said.

In Estonia, domestic factors — including a structural budget deficit that pumps too much money into the economy — have played a much larger role than interest rates in driving up prices, according to Rasmus Kattai, head of economic policy and forecasting division for Eesti Pank, Estonia’s central bank.

“It’s not monetary policy’s fault, this very high inflation in Estonia,” he said. “We were in a boom. Capacity utilization was the highest ever recorded at the end of last year.”

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Even if interest rates were higher, they would do little to address the energy price increases afflicting Estonia.

Long before the war, the government had begun disconnecting from Russia’s electricity grid and switching to the continental European alternative. The move promised greater security of supply, but has also contributed to high and volatile electricity prices.

On July 26, for example, electricity in Finland, separated from Estonia by just 50 miles of open water, cost roughly $7 per megawatt-hour while Estonians were paying more than $215 per megawatt-hour, according to the Nord Pool, an energy-trading market.

Estonia generates electricity using shale oil, wind power and natural gas. There are problems with all three.

Using more shale requires paying for carbon quotas under European environmental rules, which drives up the cost. Wind power supplies are limited and the region is short one-third of the natural gas supplies it requires, according to Hando Sutter, CEO of Eesti Energia, the state-owned energy company.

Estonia uses much less natural gas than countries such as Germany, but nonetheless faces higher bills for what it does use in the wake of the war. Gas prices in Europe are eight times higher than one year ago.

Estonia in April vowed to wean itself from Russian natural gas supplies by the end of this year. In a partnership with Finland, it is building a floating offshore platform to receive imports of liquefied natural gas.

Even if the facility is operational by November, as planned, it may be another two months before cargoes arrive, Sutter said.

In May, Sutter redrew Eesti Energia’s strategic plan to emphasize sharp increases in production from wind and solar power. By 2026, the company expects to produce 5 terawatt-hours of electricity, more than three times the 2021 figure.

“Because we need to replace gas, we need more renewable power,” he said.

Businesses, meanwhile, are scrambling to cope with mounting expenses.

Indrek Laul, a concert pianist and business executive, uses natural gas to heat the Estonia Piano Factory, located alongside a 16th-century graveyard-turned-park. But soaring energy bills convinced him to switch to an alternative fuel, liquefied petroleum gas (LPG).

Laul plans to tear down two small buildings to make room for the installation of underground LPG tanks. He’s also replacing nearly four dozen radiators with more efficient, individually controlled units. The change will shave his heating bills, his largest single expense, by more than half.

Scrapping the factory’s Soviet-era electrical wiring and adding an energy-efficient system for collecting the mountain of sawdust produced by piano making should cut his electric bill by more than one-third.

Standing in a sunny workshop in his five-story, limestone building, Laul shows off rows of half-finished grand pianos. The largest and most opulent models sell for more than $100,000 apiece.

“During covid, piano sales took off after about six months. Dealers told us ‘Send us more pianos,’ ” he said. “Now, we have an energy crisis. But demand is still up there.”

Across the economy, prices began surging last year. Annual inflation topped 12 percent in December; exceeded 15 percent in March; and hit 20 percent in May.

“Everything” is more expensive, said Natalia Saevalaje, an office administrator, and shopper at the mall. “My salary is not keeping up.”

To stretch her euros, she has begun baking her own cakes and dining out less often.

In a Eurobarometer survey completed in February, more than 70 percent of those surveyed identified the cost of living as their main worry, far higher than the 41-percent euro zone average.

Yet the same poll showed 90 percent of Estonians backed the euro, despite the escalating price increases. And the widespread public anger that has driven U.S. consumer confidence readings to record lows and threatens Democratic control of Congress this fall is absent here.

One reason for the relatively sanguine mood may lie in Estonia’s history. Occupied by Stalin’s troops in 1940, the country was swallowed by the U.S.S.R. and ruled from Moscow until 1991.

As the newly-independent nation built a market economy in the early 1990s, inflation spiked to 90 percent before settling to acceptable levels later in the decade.

“We all have families where the grandparents were taken away to Siberia,” said Sutter, the energy executive. “All our property was taken away in the Second World War. Our currency was taken away and replaced with the ruble. We all remember this — at least my generation. We’re used to hard times.”

Still, the economic hit from today’s rising prices is real. High inflation will drive annual output growth from last year’s 8.2 percent to just 1.3 percent this year, the OECD said.

Over time, excessively low interest rates will erode Estonia’s competitiveness, including by making its exports too expensive for customers outside the euro area, Bank of America economists warned in an Aug. 4 note to clients.

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On a recent weekday, next door to the oldest wooden structure in Estonia, a Russian Orthodox church built in 1721, four towering yellow cranes swiveled above a construction site.

This is where Kapitel’s office complex is taking shape. By late summer 2024, there should be four buildings here, including a 28-story tower, boasting modern ventilation systems designed to appeal to covid-scarred workers.

As the project’s cost continued climbing last year, the developer considered halting construction and acquiring an existing building instead. But it couldn’t find one it liked, said Pallo of Kapitel.

Now, the developer is hanging on, hoping that inflation will ebb and investors will overcome their concerns about Estonia’s proximity to Putin’s Russia.

The central bank says inflation is likely to remain uncomfortably high for the rest of this year, before dropping to 4.3 percent in 2023 as the energy price shock fades. Some are skeptical.

“Fundamental inputs to everything in our economy have gotten more expensive,” said Raivo Vare, a partner in Rvve Group, an investment firm, and a prominent ex-politician. “They are just starting to transfer into everything else. It’s not over yet.”