Remarks by the Governor of the Bank of Israel at the press briefing on monetary policy held at the Bank of Israel 02.01.2023
Yesterday and today, the Monetary Committee held discussions at the Bank of Israel in order to decide on monetary policy.
The Monetary Committee assessed the overall impact of the various processes affecting economic activity and inflation, and at the end of the discussions decided to increase the interest rate by 0.5 percent points to 3.75 percent.
In my remarks today, I would like to discuss some of the considerations that we took into account when making the decision. Later in my remarks, I will also refer to several issues in view of the beginning of the new government’s tenure.
Inflation in Israel has been above the upper bound of the target range for a while. The increase in prices is reflected in many CPI components and can be seen in tradable as well as nontradable goods. Our analysis indicates that a considerable portion of the inflation derives from a continued increase on the demand side of the economy.
I have said in the past, and I will say it again: High inflation involves growing uncertainty and increasing difficulty in making decisions at the household and the business levels, weighs on economic conduct, and adversely impacts growth and welfare, first and foremost amongst the weaker strata. In addition, the more entrenched inflation becomes, the harder it is to eradicate, and then ultimately the required interest rate will be even higher. We in the Monetary Committee are determined to reduce the inflation rate and to return it to within the target range. This is in order to ensure price stability, which is necessary for economic stability and a growth-supporting environment.
Alongside actual inflation, inflation expectations and forecasts provide us with important information on how market participants see the economic situation and the impact of the policy on the inflation rate. In fact, 1-year inflation expectations and forecasts from the various sources indicate that over the coming year, inflation is expected to return to within the target range of 1–3 percent. This is also seen in the Research Department’s staff forecast that was published today, and I will expand on that later on. With regard to the upcoming period, the forecasts show that the year-over-year inflation rate will increase a bit more before beginning to moderate and then decline.
Inflation expectations derived from the capital market for terms longer than the upcoming year are within the target range. This is an important indicator for the economy and of the effectiveness of the monetary policy. The anchoring of expectations within the target range is an expression of the markets’ confidence in the policy being adopted by the Monetary Committee. It is important to understand that the anchoring of these expectations is determined under what we economists call “equilibrium”—meaning expectations are anchored, among other things, through taking into account the policy that we are adopting. The decision today is consistent with the continued anchoring of forward expectations.
In addition, we are already in a restrictive environment, in which real interest rates along the curve increased in recent months and are in positive territory all along the curve. This is a result of the policy we have adopted in recent months, when we increased the interest rate relatively rapidly—a process called front-loading. Future decisions regarding the continuation of the policy and the pace at which it will be implemented will be derived from the data that will be available to the Monetary Committee and the assessments regarding inflation dynamics. This takes into account that the interest rate increases so far having been implemented at a relatively rapid pace and that the interest rate increases impact on inflation with some lag.
Inflation in Israel is lower than the inflation rate in most advanced economies. Alongside that, initial signs of moderation of inflation can be seen in some of the countries, particularly in the US. Inflation in most countries is markedly above the central bank targets and therefore the monetary tightening worldwide continues. However, we can see that major central banks have begun to slow the pace of interest rate increases that was in place until now and to signal a continued slowing of the pace.
Alongside all these, the growth rate of the Israeli economy is strong relative to other countries and GDP is near its long term trend. The various indicators of activity show expectations for continued relatively solid economic activity. The labor market remains tight, despite some weakness in recent months’ data. The unemployment rate, which increased slightly, remains low and employment rates also continue to be high. An important indicator for analyzing the labor market is the development of job vacancies. We have seen a slight decline recently in the number of job vacancies, but they are still high numbers from a historical perspective.
Wage developments are among the significant processes that we will follow in the coming months. The wage level in the business sector in recent months has been above what was expected based on the pre-crisis trend, particularly in the high tech sector. Since the beginning of the COVID-19 crisis, the rate of increase in public sector wages has been markedly less than in business sector wages. In the coming period, discussions are expected on wage adjustments required in the public sector. It is important that the wage agreements that will be signed, particularly in this period of high inflation, will incorporate the average inflation in previous years as well as that expected in the coming years. It is also important that the agreements do not include long-term rigid indexation mechanisms that are liable to adversely impact the economy’s return to a price stability environment. I have expanded on this on various occasions, and we have recommended mechanisms with regard to this issue.
We are closely following housing market developments as well. Although home prices continue to increase at a very high pace, data on building starts, permits, the number of transactions carried out and new mortgage volume support a moderation in the market. It may be assumed that these factors, to the extent that they continue, will be reflected in prices later on. In addition, we constantly follow rent prices, which are also increasing, and impact on inflation.
In capital markets in Israel and abroad, prices have declined, which characterized the past year; while alongside that, government bond yields are increasing. Since the previous policy decision, equity indices in Israel declined more than the global trend. As a result, the positive gap between equity returns in Israel and other indices worldwide from the beginning of 2022 contracted notably. At the same time, we saw widening corporate bond spreads in Israel. This is mainly the case among those bonds with lower ratings.
Alongside capital market developments, in the foreign exchange market there has been a weakening of the shekel in recent weeks, in contrast to the global trend of other currencies appreciating against the dollar. In the past year, there has been high volatility in the foreign exchange market, and I would remind us all that the exchange rate serves as a monetary-policy transmission channel. Changes in the exchange rate are frequent and their direction also changes often. The foreign exchange market is also impacted in Israel by investments by institutional investors abroad and by the returns in financial markets, while in contrast there are offsetting effects such as the current account surplus and direct investments in the economy.
The macroeconomic forecast published today by the Research Department incorporates the various developments. The Department assesses that GDP will grow in 2023 by 2.8 percent, and in 2024 by a higher rate of 3.5 percent, a pace similar to the economy’s natural potential growth rate. According to the forecast, the labor market will continue to be tight, though it will weaken slightly. The unemployment rate among the prime working ages is expected to be 4 percent in both 2023 and 2024. According to the forecast, the inflation rate is expected to be within the target range in the last quarter of 2023, and in 2024 to be at the midpoint of the target range.
However, there are still several significant causes of uncertainty that the Research Department indicates. The main risks to the forecast are a slower than expected moderation in the rate of inflation abroad; a colder than expected winter in Europe and a worsening of the war in Ukraine, which are liable to again accelerate energy prices; and the development of activity in China in view of the rise in COVID-19 morbidity. These are all liable to impact upward on the expected inflation rate and downward on economic activity. In addition, there are also domestic risks to the forecast, which depend on fiscal policy. To the extent that fiscal policy will be significantly more expansionary than the forecast projects, the expected inflation rate, the debt to GDP ratio, and capital market yields are liable to be higher.
I will take this opportunity to welcome the new government that is beginning its function at this time. The Bank of Israel is the economic advisor to the government and will help the new government as much as we can to advance the Israeli economy.
Accordingly, over the recent period, we have focused on updating the Bank’s economic recommendations to foster sustainable growth and increase productivity, and we will submit these to the incoming government. These will incorporate the economic approaches and the important reforms that we believe should be promoted in the Israeli economy in the coming years. These include the development of human capital and integrating under-represented population groups into the labor market, and promoting investments in infrastructure and reforms that support growth. These will set down foundations that will help the Israeli economy grow and develop in the coming decades.
It is important that the new government acts with the necessary responsibility with regard to fiscal policy, in particular regarding new expenditures that are not geared towards promoting sustainable growth. I have said in the past that one of Israel’s strategic assets is the low debt to GDP ratio of its economy, which served us well in the COVID-19 crisis.
Soon, budget discussions will begin, concrete proposals will be placed on the table, and the government’s intentions will be clarified. I believe that these will be fiscally responsible decisions that encourage growth, and will benefit the entire population. The Bank of Israel as the economic advisor for the government will assess these proposals in the most professional and responsible manner.
It is important to remember that the Israeli economy cannot take for granted the high regard from the rating entities and international financial institutions with which I am in constant contact. It was achieved due to the long and commendable road we have traveled in an effort lasting many years, as we became an advanced economy. As a small and open economy that interacts with the largest economies in the world, the continued trust of the markets and of the various entities in the global economy is very important to the Israeli economy and to the existence of a financial and business environment that is stable and secure.
Before concluding, I would like to thank my friend, Prof. Michel Strawczynski, who ended his role here last week after many years of work at the Bank of Israel, including serving as a member of the Monetary Committee. I wish him all the best and success going forward. In addition, I would like to welcome Dr. Adi Brender, who has been appointed Director of the Bank of Israel Research Department and member of the Monetary Committee. This is the first monetary policy decision in which he participated as a member. I and the other Monetary Committee members wish both of them great success and continued productive work.