31 July 2001
Inflation Report January-June 2001

The Governor of the Bank of Israel, Dr David Klein, today submitted the Inflation Report for January to June 2001 to the government, the Knesset and the public. The Report is part of the process of monitoring the course of inflation and adherence to the inflation targets set by the government, and is intended to increase the transparency of monetary policy. Transparency in the management of macroeconomic policy, monetary and fiscal, is an important component in increasing the degree of certainty required by nonresident investors regarding their investments in Israel, and for Israeli participants in the domestic and international financial markets. This Inflation Report was prepared at the Bank of Israel within the framework of the Senior Monetary Forum, which is headed by the Governor and comprises the heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Control Departments. The Inflation Report for the first half of 2001 highlights the following points: * The CPI rose by 1.1 percent from January to June 2001, and the current assessment is that the index will rise by between 2.0 and 2.5 percent during the whole year, close to the lower end of the target set for the year (2.5-3.5 percent), and within the target defined as long-term price stability (1-3 percent). * Monetary policy throughout the period acted against the background of domestic and external shocks, such as the crises in world capital markets, particularly the Nasdaq, the world-wide economic slowdown, and the aggravated security situation in Israel. These resulted in a deceleration in Israel’s economy, after high rates of growth from the second quarter of 1999 until the third quarter of 2000. The slowdown, reflecting mainly an easing of demand, has a moderating effect on price rises, but also increases the degree of uncertainty and carries the seeds of possible financial damage in the future. * The NIS depreciated by about 3 percent against the dollar in the period reviewed, in contrast to appreciation during 2000. The NIS/currency-basket exchange rate was stable, at 1-2 percentage points above the lower limit of the exchange-rate band. This stability is all the more notable in the light of the security unrest and the instability of capital markets abroad, which could have resulted in a faster rate of depreciation. * With the intention of attaining the inflation target, while assessing that expected inflation was below the target for 2001 (at the rates of interest prevailing when the decisions were made), the Bank of Israel reduced the rate of interest gradually and constantly by a cumulative 1.4 percentage points during the first half of 2001, and by another 0.5 percentage point since then. At the end of July 2001 interest was down to 6.3 percent, so that the cumulative reduction since the beginning of 1999 totals 7.2 percentage points. The lowering of the Bank of Israel interest rate in the period reviewed acted to reduce the real rate of interest and encourage economic activity. * The rate at which the Bank of Israel brought the interest rate down was affected by the need to maintain financial stability, particularly in the light of a) the possibility that a sharp fall in capital raised abroad by Israeli companies would lead to faster depreciation; b) the uncertainty that prevailed throughout the period reviewed regarding the government’s expected fiscal policy and its determination to adhere to the deficit target set for the year 2001 and the next two years; c) the implications of the security situation. Against this backdrop, an assessment was reached that sharp cuts in the rate of interest would be likely to undermine financial stability, to jeopardize the achievement of the inflation targets for the next few years, and would in due course necessitate a rise in the interest rate, which would adversely affect the credibility of the policy. * The Bank of Israel notes that the proximity of the exchange rate to the lower limit of the band despite the depreciation of the NIS against the US$, affected inter alia by the weakness of the euro, again draws attention to the serious problem presented by the inconsistency of the exchange-rate band with a regime of inflation targets, especially at a time of convergence to price stability and when there is long-term capital inflow unrelated to short-term interest-rate differentials. This problem, together with the quantitative ceiling on the issue of Treasury bills, inflicts a higher rate of interest on the economy than would be needed to maintain price stability, impairs the development of the money market and the contraction of the banks’ net interest margin, and harms the robustness of the foreign-currency market by making it function under variable conditions. * The indicated deviation of the budget deficit from the maximum set for 2001, which will also be reflected in a significant rise of government expenses as a share of GDP and of the public debt-contrary to declared policy and their downward trend in the last few years-creates a problematic starting point for the budget for 2002. In addition, the lack of clarity regarding the extent of the deviation from the deficit ceiling for 2001, and even more so regarding the return to the deficit path planned for the next few years as part of the convergence to international standards, is likely to prevent the continued reduction of the real long-term rate of interest and may even cause it to rise, and thereby postpone investment and retard growth, harm price stability in the future, and necessitate adjustments of monetary policy to preserve stability.