Summary:
The consumer price index rose by a moderate 1.2 percent in 2004, after falling by 1.9 percent in 2003 and rising by 6.5 percent in 2002. The housing price component of the index dropped by 2.5 percent in 2004 while the CPI excluding housing rose by 2.3 percent. The rate of increase in the CPI during 2004 was close to the lower limit of the targeted rise in the index of between 1 and 3 percent defined as price stability that was set with respect to 2003 onwards. This followed an exceptional downward deviation in 2003 and an upward deviation in 2002. The moderate development of prices during the last two years and other indicators (which will be detailed later) support the assessment that the price stability which characterized the Israeli economy since 1999, although temporarily disturbed in 2002 and 2003, is not a transitory phenomenon. During the years 1999 to 2004, consumer prices rose by an annual average rate of 1.4 percent, compared with an annual average rate of 10 percent during the years 1992 to 1998.
The main factors responsible for the slow pace of price increase in 2004 were the moderate development of the exchange rate in the course of the year, following the decline in the exchange rate during 2003, and the continued slump in activity and in the labor market during the years 2001 to 2003. Despite the rapid expansion of business sector activity in 2004 (see below), the sector still remained with production capacity surpluses. This was apparent from the modest development of wages and unit labor cost in the business sector. Nominal wages per employee post (FTE) rose by a moderate 1.5 percent in 2004 following a decrease of 1.8 percent in 2003, and the nominal unit labor cost (the proportion of the wage bill in business sector GDP) fell by 2.8 percent following a decrease of 3.9 percent in 2003.1 It should be noted that the continued decrease in unit labor cost in 2003 and 2004 followed on from a moderate increase during the years 2000 to 2002. The trend in this indicator was undoubtedly a major factor behind the moderate pace of price developments during recent years as a whole and during the past two years in particular.
Price developments in 2004 were affected by the moderate development of the exchange rate, which fell by 1.2 percent against the dollar and rose by 1.8 percent against the currency basket, after declining by 6.4 percent against the dollar and 0.5 percent against the currency basket in 2003.3 The development of the exchange rate and consumer prices was not uniform in the course of the year. The shekel rose against the dollar by 2.9 percent and consumer prices increased by 1.4 percent in the first half of the year, but fell by 3.9 percent and 0.2 percent respectively in the second half.
During the first four months of the year, the Bank of Israel maintained the process of interest rate reduction that began in 2003. This was due inter alia to the low level of inflation expectations for a year ahead (as reflected by capital market data and professional forecasters' assessments) in the first quarter of the year, a level that was below the center of the targeted range of inflation. During January-April, the Bank of Israel cut the interest rate by a cumulative 1.1 percentage points. From May to November, the interest rate was left unchanged. In December, the rate was cut by 0.2 percentage points and in each of the months January and February 2005, was cut by another 0.2 percentage points to a level of 3.5 percent. The Bank of Israel's interest rate in real terms (the nominal interest rate, less inflation expectations for a year ahead derived from the capital market) also fell during the initial months of the year, and in the second half of 2004 reached an average of 2.3 percent compared with 4.6 percent in December 2003.
The Bank of Israel maintained the process of interest rate reduction during the four months of 2004 despite the rise in medium and long-term interest rates, which are determined by the markets,5 and the upturn in the exchange rate (against both the dollar and the currency basket) in that period. Concurrent with the interest rate reduction, inflation expectations for a year rose, and in May 2004 market expectations reached 2.0 percent while private forecasters' assessments reached 2.6 percent. The moderate upturn in bond yields (which matched the development of bond yields in the USA during the same period) ceased in mid-year. In the second half of the year, long-term yields-to-maturity stabilized and short and medium-term yields fell slightly, developments that were behind the Bank of Israel's decision to cut the interest rate in December 2004. During the year as a whole, the differential between long and short-term interest rates expanded (the slope of the real and nominal yield curves became steeper), a development that was indicative of monetary expansion.
The downtrend in CPI-indexed and unindexed bond yields for all terms continued during December 2004 and January 2005, developments that affected the decision to further reduce the interest rate in January and February 2005.
Despite the contraction in the differential between the monetary interest rates in Israel and the USA (as a result of the Bank of Israel's reduction in the interest rate during the initial months of the year and the continued rise in the interest rate in the USA during the second half), the shekel strengthened against the dollar in the second half of 2004 due to the concurrent weakening of the dollar against the euro. The fall in the exchange rate against the dollar during the second half of the year had the effect of reducing consumer prices in that half.
A major factor that contributed to exchange rate and price stability in 2004, and which facilitated a further reduction in the monetary interest rate, was the government's budgetary policy. This policy was reflected by a decrease in domestic public consumption, and by a reduction in the budget deficit and government borrowing for the purpose of financing the deficit. The budget deficit amounted to 3.9 percent of GDP in 2004, close to the target of 4.0 percent of GDP and compared with a deficit of 5.6 percent of GDP in 2003. The government's domestic borrowing totaled NIS 13.0 billion in 2004, compared with NIS 23 billion and NIS 24 billion respectively in 2003 and 2002.
The moderate development of the exchange rate and prices, concurrent with the combination of an expansionary monetary policy and contractionary fiscal policy, supported a rapid growth in activity and employment in the business sector during 2004. Leading the growth in activity in 2004 were the decline in the entire range of interest rates in 2003 and the increase in global activity in 2004. The 6.2 percent growth in business sector GDP was based on a rapid 14.6 percent expansion in exports and a 5.2 percent increase in private consumption. Domestic public consumption fell by 1.5 percent, and investment in fixed assets dropped by 2.1 percent. The fall in investment was comprised of a further decrease in investment in housing, structures and other construction works - 6 and 10 percent respectively - and an 8 percent increase in investment in machinery, equipment and transportation equipment, a turnaround that followed a continued decline during the years 2001 to 2003.
In contrast to the moderate development of consumer prices, the wholesale price index rose by 2.9 percent and 5.2 percent respectively in 2003 and 2004. The relatively rapid increase in wholesale prices appears to have resulted from the increase in the prices of raw materials, most of which are imported from the eurozone, due to the strengthening of the euro against the dollar in recent years. During the years 2002 to 2004 the shekel depreciated against the euro by an annual average of 11 percent as compared to 1 percent against the dollar. Concurrent with the strengthening of the euro, the dollar prices of imported inputs for domestic production rose by 5.6, 8.5 and 15.7 percent respectively in the years 2002 to 2004.
The large increase in world prices for oil contributed to the steep rise in the prices of imported inputs in 2004. The fact that the increase in the prices of imported inputs and wholesale prices was not reflected by a rise in consumer prices can be attributed to the relatively low level of domestic demand resulting from the recession in previous years. In addition, the increase in prices of imported consumer goods was less than that of imported production inputs, and amounted to 1.4 percent, 6.8 percent and 2.8 percent in dollar terms respectively during the years 2002 to 2004.
In an inflation targeting regime, in which the central bank's interest rate is the principal tool for the management of monetary policy, the money supply in the economy is determined by demand on the part of the public. In 2004 the means of payment (M1) expanded by 19 percent. This expansion, which is much higher than that derived from the increase in activity and prices, mainly reflects a delayed response to the large decline in the nominal interest rate during 2003 and at the beginning of 2004. The broader monetary aggregate (M2), which includes time deposits, expanded by a more moderate rate of 8 percent in 2004, following an increase of 2.5 percent in 2003. This development, reflecting a slow pace of expansion in time deposits, partly resulted from the relatively rapid growth in the supply of Treasury bills, which serve as a substitute for deposits of the public at the banks.
Bank credit to the public, which expanded considerably during the years 2000 to 2002, at an average annual rate of 10 percent, remained stable in 2004 after contracting by 2.8 percent in 2003. The moderate development of bank credit during the last two years reflects the stricter terms that the banking system imposed for the extension of credit. Demand for credit appears to have increased in view of the rapid growth in business activity. The private sector supplied businesses' growing demand for credit by means of an increased volume of private issues. This increase was due to the decrease in government borrowing and the decline in interest rates during the last two years.
Chapter 1: Main Developments -PDF file
The main factors responsible for the slow pace of price increase in 2004 were the moderate development of the exchange rate in the course of the year, following the decline in the exchange rate during 2003, and the continued slump in activity and in the labor market during the years 2001 to 2003. Despite the rapid expansion of business sector activity in 2004 (see below), the sector still remained with production capacity surpluses. This was apparent from the modest development of wages and unit labor cost in the business sector. Nominal wages per employee post (FTE) rose by a moderate 1.5 percent in 2004 following a decrease of 1.8 percent in 2003, and the nominal unit labor cost (the proportion of the wage bill in business sector GDP) fell by 2.8 percent following a decrease of 3.9 percent in 2003.1 It should be noted that the continued decrease in unit labor cost in 2003 and 2004 followed on from a moderate increase during the years 2000 to 2002. The trend in this indicator was undoubtedly a major factor behind the moderate pace of price developments during recent years as a whole and during the past two years in particular.
Price developments in 2004 were affected by the moderate development of the exchange rate, which fell by 1.2 percent against the dollar and rose by 1.8 percent against the currency basket, after declining by 6.4 percent against the dollar and 0.5 percent against the currency basket in 2003.3 The development of the exchange rate and consumer prices was not uniform in the course of the year. The shekel rose against the dollar by 2.9 percent and consumer prices increased by 1.4 percent in the first half of the year, but fell by 3.9 percent and 0.2 percent respectively in the second half.
During the first four months of the year, the Bank of Israel maintained the process of interest rate reduction that began in 2003. This was due inter alia to the low level of inflation expectations for a year ahead (as reflected by capital market data and professional forecasters' assessments) in the first quarter of the year, a level that was below the center of the targeted range of inflation. During January-April, the Bank of Israel cut the interest rate by a cumulative 1.1 percentage points. From May to November, the interest rate was left unchanged. In December, the rate was cut by 0.2 percentage points and in each of the months January and February 2005, was cut by another 0.2 percentage points to a level of 3.5 percent. The Bank of Israel's interest rate in real terms (the nominal interest rate, less inflation expectations for a year ahead derived from the capital market) also fell during the initial months of the year, and in the second half of 2004 reached an average of 2.3 percent compared with 4.6 percent in December 2003.
The Bank of Israel maintained the process of interest rate reduction during the four months of 2004 despite the rise in medium and long-term interest rates, which are determined by the markets,5 and the upturn in the exchange rate (against both the dollar and the currency basket) in that period. Concurrent with the interest rate reduction, inflation expectations for a year rose, and in May 2004 market expectations reached 2.0 percent while private forecasters' assessments reached 2.6 percent. The moderate upturn in bond yields (which matched the development of bond yields in the USA during the same period) ceased in mid-year. In the second half of the year, long-term yields-to-maturity stabilized and short and medium-term yields fell slightly, developments that were behind the Bank of Israel's decision to cut the interest rate in December 2004. During the year as a whole, the differential between long and short-term interest rates expanded (the slope of the real and nominal yield curves became steeper), a development that was indicative of monetary expansion.
The downtrend in CPI-indexed and unindexed bond yields for all terms continued during December 2004 and January 2005, developments that affected the decision to further reduce the interest rate in January and February 2005.
Despite the contraction in the differential between the monetary interest rates in Israel and the USA (as a result of the Bank of Israel's reduction in the interest rate during the initial months of the year and the continued rise in the interest rate in the USA during the second half), the shekel strengthened against the dollar in the second half of 2004 due to the concurrent weakening of the dollar against the euro. The fall in the exchange rate against the dollar during the second half of the year had the effect of reducing consumer prices in that half.
A major factor that contributed to exchange rate and price stability in 2004, and which facilitated a further reduction in the monetary interest rate, was the government's budgetary policy. This policy was reflected by a decrease in domestic public consumption, and by a reduction in the budget deficit and government borrowing for the purpose of financing the deficit. The budget deficit amounted to 3.9 percent of GDP in 2004, close to the target of 4.0 percent of GDP and compared with a deficit of 5.6 percent of GDP in 2003. The government's domestic borrowing totaled NIS 13.0 billion in 2004, compared with NIS 23 billion and NIS 24 billion respectively in 2003 and 2002.
The moderate development of the exchange rate and prices, concurrent with the combination of an expansionary monetary policy and contractionary fiscal policy, supported a rapid growth in activity and employment in the business sector during 2004. Leading the growth in activity in 2004 were the decline in the entire range of interest rates in 2003 and the increase in global activity in 2004. The 6.2 percent growth in business sector GDP was based on a rapid 14.6 percent expansion in exports and a 5.2 percent increase in private consumption. Domestic public consumption fell by 1.5 percent, and investment in fixed assets dropped by 2.1 percent. The fall in investment was comprised of a further decrease in investment in housing, structures and other construction works - 6 and 10 percent respectively - and an 8 percent increase in investment in machinery, equipment and transportation equipment, a turnaround that followed a continued decline during the years 2001 to 2003.
In contrast to the moderate development of consumer prices, the wholesale price index rose by 2.9 percent and 5.2 percent respectively in 2003 and 2004. The relatively rapid increase in wholesale prices appears to have resulted from the increase in the prices of raw materials, most of which are imported from the eurozone, due to the strengthening of the euro against the dollar in recent years. During the years 2002 to 2004 the shekel depreciated against the euro by an annual average of 11 percent as compared to 1 percent against the dollar. Concurrent with the strengthening of the euro, the dollar prices of imported inputs for domestic production rose by 5.6, 8.5 and 15.7 percent respectively in the years 2002 to 2004.
The large increase in world prices for oil contributed to the steep rise in the prices of imported inputs in 2004. The fact that the increase in the prices of imported inputs and wholesale prices was not reflected by a rise in consumer prices can be attributed to the relatively low level of domestic demand resulting from the recession in previous years. In addition, the increase in prices of imported consumer goods was less than that of imported production inputs, and amounted to 1.4 percent, 6.8 percent and 2.8 percent in dollar terms respectively during the years 2002 to 2004.
In an inflation targeting regime, in which the central bank's interest rate is the principal tool for the management of monetary policy, the money supply in the economy is determined by demand on the part of the public. In 2004 the means of payment (M1) expanded by 19 percent. This expansion, which is much higher than that derived from the increase in activity and prices, mainly reflects a delayed response to the large decline in the nominal interest rate during 2003 and at the beginning of 2004. The broader monetary aggregate (M2), which includes time deposits, expanded by a more moderate rate of 8 percent in 2004, following an increase of 2.5 percent in 2003. This development, reflecting a slow pace of expansion in time deposits, partly resulted from the relatively rapid growth in the supply of Treasury bills, which serve as a substitute for deposits of the public at the banks.
Bank credit to the public, which expanded considerably during the years 2000 to 2002, at an average annual rate of 10 percent, remained stable in 2004 after contracting by 2.8 percent in 2003. The moderate development of bank credit during the last two years reflects the stricter terms that the banking system imposed for the extension of credit. Demand for credit appears to have increased in view of the rapid growth in business activity. The private sector supplied businesses' growing demand for credit by means of an increased volume of private issues. This increase was due to the decrease in government borrowing and the decline in interest rates during the last two years.
Chapter 1: Main Developments -PDF file