Previous Inflation Reports
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Inflation Report 2005, January - June
Letter of the Governor, Professor Stanley Fischer
Jerusalem, July 2005
The Inflation Report for the
first half of 2005 is submitted to the government, the Knesset and the public
as part of the process of periodic monitoring of the course of inflation and
adherence to the inflation targets set by the government.
The Consumer Price Index
(CPI) rose by 0.5 percent in the first half of 2005, and over the last twelve
months by 0.3 percent, below the lower limit of the target range (inflation of
between 1 percent and 3 percent a year). At the beginning of the year the Bank
of Israel reduced its interest rate in two steps to 3.5 percent, with the
intention of raising the inflation rate to within the target range. The Bank's ability
to reduce its interest rate and to hold it at a low level, contrary to previous
assessments in the capital market that the interest rate would be raised during
the period, reflected stability in the financial markets and inflation
expectations that were around the midpoint of the target range. The maintenance
of fiscal discipline made it easier to pursue an expansionary monetary policy
that encouraged economic activity.
The question arises: why was
the rate of inflation in the last twelve months below the target range despite
the cuts in the Bank of Israel interest rate and its low level? The main reason
is that the rate at which the exchange rate rose in that period was slower than
had been expected. A year ago the assessments in the financial markets, in the
Bank of Israel Companies Survey, and those of private forecasters, all pointed
to two factors that would cause the NIS to depreciate against the dollar, and
hence would raise prices to within the target range: the contraction of the
interest-rate differential between the US and Israel, and the equalization of
tax rates on foreign and domestic assets at the beginning of 2005. In practice,
the exchange rate remained stable for most of the period (to June) despite the
cuts in the interest rate, against the background of a significant inflow of
long-term capital to Israel.
Economic growth continued in
the range of 3.5–4 percent during the first half of the year, and is expected
to continue at similar levels in the next half-year and in 2006. Recent declines
in unemployment also indicate the consolidation of growth and companies'
assessment that it will continue. Growth is being powered by the rise in
private consumption and the continued increase in exports, albeit at a slower
rate than in 2004 due to a slowdown in the growth of world trade. The
continuation of growth in this period was supported by the credibility of
fiscal policy––which, together with monetary policy, was reflected in low
interest rates––and the extended calm in the security situation. These factors,
as well as the relatively favorable environment in the global economy, are
expected to continue and to support growth in the coming year too. However,
there is as always some uncertainty about the growth forecast. For example, if
the security and geopolitical situation should deteriorate to a considerable
extent, or if world economic and trade growth slow down significantly, the rate
of growth in Israel is likely to be lower than currently predicted.
Inflation is expected to
rise in the next twelve months, to a rate within the target range. This will
result from continued growth and reduced unemployment, from the low level of
the real interest rate, and from the depreciation that has already occurred.
Monetary policy will act to achieve the targeted inflation range, and endeavor
to prevent both downward and upward deviations from it, while preserving
financial stability. At the same time it will support the government's economic
objectives, with sustainable growth heading the list.
Stanley Fischer
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Governor
Summary
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The Consumer Price Index
(CPI) went up by a cumulative 0.5 percent in the first half of 2005, and by 0.3
percent in the last twelve months––a rate below the lower limit of the
inflation target range of 1–3 percent. This is a continuation of the
low-inflation environment that prevailed in the last two years. |
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The Bank of Israel continued
to lower the interest rate at the beginning of the period reviewed. This took
place against the background of a moderate level of price increases, inflation
expectations that were within the inflation target range, a reduction in bond
yields, and stable domestic currency markets. Thus the interest rate was cut by
0.2 of a percentage point in each of the months December 2004, and January and
February 2005, to reach the low level of 3.5 percent. |
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In the second quarter the
capital and money markets remained stable, while the short-term-interest
differentials continued to contract. It seemed that inflation in the next
twelve months was expected to be close to the midpoint of the price stability
target range. The Bank of Israel therefore kept the interest rate for the
months March to June unchanged. |
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The NIS/dollar exchange rate
is known to have a considerable effect on price changes in Israel, both via its
effect on housing prices (most of which are quoted in dollars), and via its
effect on imported goods. For most of the first half-year the NIS was traded
with no clear trend and with low volatility, and constituted a major reason for
the small rise in the CPI. In June the NIS depreciated sharply against the
dollar, and the effect of this on prices has not yet been realized in full. |
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Global factors, headed by
the strengthening of the dollar world wide, served for most of the period
reviewed to weaken the NIS (against the dollar), while domestic developments
had only a minor effect. In contrast the rapid depreciation that occurred in
June was due almost entirely to domestic factors. |
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The differential between the
short-term interest rates of the US Federal Reserve and the Bank of Israel
stood at only 0.25 percentage points at the end of the period reviewed. The
contraction of the differential to this unprecedented level without causing
shocks in the Forex market could occur in the light of the decline in Israel's
country risk and the rise in the US dollar currency risk. |
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The continued growth of
economic activity in the first half of the year, albeit at a slower rate than
in the equivalent period in 2004, and the sharp fall in the unemployment rate
in the first quarter of 2005 did not cause upward pressure on prices, as a
result of spare production capacity in the economy. |
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Two other stabilizing
influences affected price rises and monetary policy in the period reviewed: (a)
fiscal discipline, which the public afforded credibility despite the delay in
approving the budget, and which was reflected by the reduction of future yields
on long bonds; and (b) the relative calm in the security situation in Israel at
this time. |
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The rate of inflation in the
last twelve months, which was below the target range, as stated above, was also
lower than the level forecast a year earlier. At the end of the first half of
2004 inflation expectations––derived from the capital market, private
forecasters, responses of companies participating in the Bank of Israel's
Company Survey, and Bank of Israel models––were within the price-stability
target range, with a rise expected in the Bank's interest rate. The difference
between actual inflation and that which had been predicted derived mainly from
the assessments a year earlier that the contraction of the interest–rate
differential between Israel and abroad and the equalization of tax rates on
domestic and foreign assets would lead to NIS depreciation against the dollar,
and hence to price increases. The depreciation did not occur, as mentioned
above, despite the response of Israelis to the contraction of the interest-rate
differential, mainly due to large unanticipated inflows of capital from
nonresidents into the economy. |
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Current assessments and
expectations––derived from the capital market, private forecasters, companies
participating in the Company Survey, and Bank of Israel models––are that prices
will rise somewhat faster during the year to a rate close to the midpoint of
the target range (2 percent). Some of these assessments are based on the
assumption that the Bank of Israel interest rate will be raised a little
towards the end of the year. Simulations carried out in the Bank of Israel
using economic models show that if the NIS/dollar exchange rate settles at the
level it reached at the end of June, and the Bank of Israel interest rate also
remains at its present level, the rate of price increases in 2005 will be close
to the upper limit of the target inflation range, and in the next twelve months
is even likely to exceed it and make it necessary to raise the interest rate
thereafter. Under these assumptions, according to the models, a higher rate of
inflation than that prevailing hitherto will be caused by continued growth, the
reduction of unemployment, the low level of real interest, and the depreciation
that has already taken place. |
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