Sept. 17 (Bloomberg) -- Latvia's economy may contract for the next 18 months as housing prices fall and credit conditions tighten further, two Riga-based economists said in a report today.

The economy, which expanded 0.1 percent in the second quarter, may shrink 1 percent this year and in 2009, according to a report by Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics.

The Baltic state's economy has faltered after real estate prices fell, consumer spending dipped and credit became more expensive. The speed of the slowdown has taken the government by surprise and threatens to create budget deficits this year and next.

Latvia faces a ``particularly nasty cocktail of a bursting credit bubble, a bursting property bubble, soaring energy and food prices, and a world economic slowdown,'' the report said. ``The Latvian economy is facing a very grim near future.''

The country's inflation rate peaked in May when it reached 17.9 percent, and will continue to fall as the economy slows, they said. The labor market has ``surely been the main culprit'' in higher consumer prices in Latvia, the report added.

For inflation to fall below 10 percent in Latvia, unemployment may have to rise above 10 percent, Hansen said at a conference today. Unemployment declined to 6.3 percent in the second quarter from 6.5 percent in the previous three-month period, the central statistics office said on Aug. 20.

``It is rather clear, even to the most optimistic officials and bankers, that Latvia is facing at best a period of stagflation and at worst a full-blown recession the like of which has not been experienced in post-Soviet Latvia,'' they said in the report.

To contact the reporter on this story: Aaron Eglitis in Riga at aeglitis@bloomberg.net

Last Updated: September 17, 2008 08:01 EDT