As you know, the Monetary Committee decided today to keep the interest rate at 0.1 percent, and reiterated that it intends to maintain the accommodative policy as long as necessary in order to entrench the inflation environment within the target range. Further in my remarks, I will sharpen and clarify the significance of this phrase.
The macroeconomic picture presented to the Committee during the course of the monetary discussions it held over the past two days is similar to the one conveyed in recent months: The economy continues to grow at an adequate pace that is line with the potential growth rate, with a tight labor market in a full employment environment. There has been a slight increase in the inflation environment, but it is still markedly lower than the target. The global economy, and with it world trade, continue to expand, but the risks to continued growth have increased. I will now detail the various developments and their expected impacts on monetary policy in Israel.
The inflation rate has been on a moderate upward trend since the summer, and for several months now the annual inflation rate has been positive, though, as noted, it remains below the target. The direct impact on inflation of the administrative price reductions is lower than it was during most of the period in which the inflation rate was negative, and is estimated at 0.4 percentage points. Recall that monetary policy does not attempt to act against this effect or to offset it. However, beyond this impact, there are increasing signs that the enhancement of competition in the economy has a prolonged effect on inflation. Thus, for example, in the past two years the Bank of Israel’s Annual Report has discussed the effect of increased purchases via the Internet, in Israel and abroad, on prices in the economy. It is difficult to identify or quantify these desirable effects, but it is clear that they are delaying the return of inflation to the target. In the opposite direction, there are several factors that are supporting an increase in inflation, primarily the tight labor market, reflected in an extended increase in wages, which in the past year also translated into an increase in unit labor cost. The increase in inflation worldwide was reflected in an increase in the inflation rate of tradable goods prices, though it remains negative. The development of the exchange rate, particularly the appreciation vis-à-vis the dollar, contributed markedly to the decline in tradable goods prices in recent years; recently, however, the exchange rate stabilized. The rise in actual inflation and the accumulation of factors expected to continue working toward its increase are reflected in a moderate increase in short-term inflation expectations and forecasts, but according to most of them, the inflation rate in the coming year is expected to remain below the target; inflation expectations for longer terms remain anchored within the target range.
Economic activity continues to expand at an adequate pace, supported by accommodative monetary policy, as well as by fiscal policy, which is expected to continue to be relatively expansionary in 2018. The composition of growth is again balanced: exports are growing at a solid pace, though there is variance between the high growth rate of services exports and the relatively moderate growth of goods exports, which has been performing less than what would have been expected based on the growth rate of world trade in goods. There are several indications that the output gap has closed, and that the economy is constrained by the potential growth rate: for example, enhanced imports, as a response to growth of domestic demand, and of course labor market data: besides a decline in unemployment and the high rates of employment and participation, there is continued growth in the job vacancy rate, and an increasing share of companies in nearly all industries are reporting that the ability to hire workers is a constraint on their expansion of activity. Further evidence is the decline in the growth rate of the number of employee posts, which had been increasing from the beginning of the growth episode in 2013 until the middle of 2016. The construction industry is an exception, where the slowdown is reflected in National Accounts data on investment in residential construction and building starts, as well as the decline in job vacancies in the industry. Beyond that, the indicators available to us make it possible to assess that in the first quarter as well the economy continued to grow by a relatively high rate.
Against the background of the growth of the stock of homes in recent years, the trend of rapid increase in home prices has halted, and in the past five months prices declined. The slowdown in the industry was reflected in a decline in the number of transactions, and after an extended decline, new mortgage volume stabilized, despite a decline in mortgage interest rates. As I noted, the data point to a decline in investment in residential construction and in building starts. In contrast, the high level of the number of building permits illustrates that supply can be increased within a relatively short period of time, and it is important that the government continues to work to that end.
The global economy continues to grow at a relatively high pace; fourth quarter growth data, as well as forecasts for the first quarter, are good in most major economies. The international institutions revised upward their growth forecasts for major advanced economies and for world trade; it is assessed that the expansionary fiscal policy in the US, and the monetary policy that is expected to remain very accommodative in Europe and Japan, will support continued growth. With that, the risks to growth have strengthened. I have noted here in the past the negative impact that there is liable to be if calls to limit world trade are reflected in actual measures, After some time in which such concerns diminished, the term “trade war” has returned to the top of global economic discussions. At this point, significant concrete steps that already have an impact on trade have not been taken, and it can be hoped that the sides will reach agreements that prevent an adverse impact to world trade, which has made an extremely important contribution to growth and to an increase in the standard of living over recent decades, mainly for small open economies such as Israel’s. In the meantime, the impact of the various media reports on the issue is mainly causing volatility in financial markets, which were also negatively impacted by developments regarding the large technology companies. A possible deterioration in geopolitical tension can also adversely impact the global economy’s ability to continue to grow, as can a worsening of financial conditions, which until now have been amenable and supported growth.
After a prolonged appreciation in recent years, the effective exchange rate stabilized in the past year. In recent months, the foreign exchange market was volatile—in December 2017 and January 2018, there was a marked appreciation, which was halted with the help of significant foreign exchange market intervention by the Bank of Israel, and since we met here the last time, there has been a cumulative depreciation of 3.5 percent in the effective exchange rate of the shekel. However, while, as noted, services exports are growing by a high rate, the cumulative appreciation in recent years has led to the current exchange rate level making it difficult for goods exports keep track with the growth rate of world trade, and while the appreciation partly expressed the relatively good state of the Israeli economy, at its current level the exchange rate remains overvalued. Further widening of the interest rate gap vis-à-vis the US as a result of continued accommodative policy in Israel together with an interest rate increase in the US is expected to strengthen the forces weakening the shekel. Likewise, the current account surplus, which in 2015 was greater than 5 percent of GDP, decreased to 3 percent of GDP in 2017, and its decline is expected to reduce appreciation pressure. In any case, the Bank of Israel will continue to purchase foreign exchange within the framework of the “Natural Gas Plan”, and to the extent necessary, will not hesitate to purchase foreign currency to moderate atypical fluctuations that are not in line with fundamental economic conditions.
The Research Department presented its macroeconomic staff forecast (recall that it is a conditional forecast based on assumptions regarding exogenous variables) to the Monetary Committee, and published it today. The forecast is very similar to that compiled by the Department 3 months ago: GDP is expected to grow by 3.4 percent in 2018 and by 3.5 percent in 2019; this outcome depends to a large extent on forecasts for continued solid growth in world trade materializing. Similar to the previous forecast, the annual inflation rate is expected to converge to the target range in the second half of 2018, and the interest rate path did not change. I reiterate that it is important to pay attention to the fan charts that describe the broad range of uncertainty that characterizes the forecast for the various variables.
As I noted in my opening comments, the Monetary Committee’s press release again notes that it intends to maintain the accommodative policy as long as necessary in order to entrench the inflation environment within the target range. In contrast to actual inflation, for which we have precise figures, “inflation environment” is a less precise term. When the Monetary Committee attempts to assess the inflation environment it primarily analyzes the combination of actual inflation, with an emphasis on inflation indices net of various one-off effects, and short-term inflation expectations. In order to establish that the inflation environment is entrenched within the target range, the Committee will also examine expectations and forecasts from various sources, and will keep the accommodative policy until it is convinced that the return of inflation to the target is not temporary and it is in fact entrenched. Currently, both actual inflation and inflation expectations are still below the target, and therefore the Committee decided to keep the accommodative policy in place.
Thank you, and have a happy Independence Day