Maintaining Price Stability is one of the main functions of the Bank of Israel, as it is with most central banks around the world. In most developed countries this has been defined as a 2% annual rise in prices. In Israel, it is defined as a range around 2%. This is not a magical number, but one that is sufficiently low that we can easily understand whether a price of a specific good really goes up or down, and adjust our behavior accordingly. This is very important to the market economy, since ensures that the market will play its role of properly allocating resources based on the signals it gets from the changes in relative prices. The 2% level is also sufficiently high that it allows downward adjustments of prices when needed in markets with relative price rigidity such as the labor market, and also allows for the erosion of the debt burden in times of recession, thus supporting economic activity when needed. Iin recent years, due to the very low inflation in many countries, the professional debate has focused on the possibility of raising the inflation target to 3 or 4%. The debate is still on-going, despite the rise in inflation and its convergence to the target in most advanced economies, this time due to lower estimates of the natural real interest rate, such as the one published by the Fed. If indeed this unobservable natural rate drops, it will be more difficult for monetary policy to provide the necessary impetus for economic activity in times of recession, so some suggest that higher inflation may be needed to provide monetary policy with “room to maneuver”. We do not think this is the case in Israel, and thus the 1-3% range is, in our view, the appropriate target for price stability.
For a number of years, actual inflation and the inflation environment in Israel have been below this target, and we think that the data support the view that we are now approaching this target. Although inflation for the past 12 months is still below the target range, at 0.5%, the various adjusted price indices are somewhat higher, and one-year-ahead inflation expectations have all moved up close to or within the target range. This has not been the case for a number of years. In addition, there are also inflationary winds blowing from abroad, as reflected by inflation in the prices of tradable goods in Israel, and inflation in the major economies, where some developed economies have reached their price stability targets and oil prices have started to rise again. At home, the exchange rate has been relatively stable and wages are continuing to rise at a fast pace, particularly in the business sector, reflecting the tight labor market in most sectors. However, for the Monetary Policy Committee to be convinced that this rise in inflation is entrenched within the target range, inflation will neet to be somewhat higher than the lower bound of the range, and the Committee will have to be convinced that the level will be persistent for more than a few months. Changing the monetary stance too early may prove counterproductive as it would delay a return to entrenched inflation within the target range.
An analysis of real economic activity shows that growth is robust, and that activity has pretty much reached its full potential. The various indicators point to continued growth at around 3.5% a year, and that the labor market is strong. However, goods exports have been disappointing during the past few months, and the most recent forecasts by foreign investment houses point to reduced global growth for the next two years. World trade which had increased vigorously during the past year, has declined somewhat lately, and a worsening of the trade war could certainly have an impact on its continued expansion. As a small open economy, Israel would be affected negatively.
These developments have occured while the financial environment in Israel is relatively stable, home prices have stabilized in the two most recent months for which data are available (February and March) after declining by 2.4 percent from their peak in August of last year, and household debt levels, though rising, are still moderate, as presented in the Bank of Israel’s most recent Financial Stability Report.
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sum up:
- The inflation environment is increasing and drawing close to the target range.
- The growth rate is robust and close to potential.
- The increasing risk of a worsening of the trade war may have a negative impact on growth.
- The financial environment is relatively stable, but there are areas of vulnerability.