Previous Inflation Reports
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Inflation Report 2005, July - December

Letter of the Governor, Professor Stanley Fischer

Jerusalem, January 2006

The Inflation Report for the second 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 Report was prepared in the Bank of Israel within the framework of the Senior Monetary Forum, headed by the Governor, the Forum in which the Governor makes decisions on the interest rate.

The Consumer Price Index (CPI) rose by 1.9 percent in the second half of 2005 (an annual rate of 3.8 percent), after rising by 0.5 percent in the first half (1 percent annual rate). During the year as a whole the index rose by 2.4 percent, within the long-term target range of price stability set by the government (inflation between 1 percent and 3 percent a year).

The main reasons for the rise in prices in 2005 were the relatively rapid 6.8 percent rise in the NIS/$ exchange rate in 2005; this rise occurred mainly in the second half of the year, and was partly due to the narrowing of the interest-rate differential between the NIS and the dollar, and the global increase in oil prices. The rise in the exchange rate acted to raise housing prices and the prices of the imported goods in the CPI, which went up faster than did domestic prices. The relatively modest increase in prices of nontradables (excluding housing) supports the assessment that in 2005 domestic factors––demand and pay increases––did not exert upward pressure on prices, although the moderating influence that these factors had exerted in 2003 and 2004 came to an end. The ongoing process of globalization also contributes to the moderation of the rise in wage and price increases: potential competition from abroad restrains wage and price increases in several of the principal industries. However, the transition from the 1.9 percent fall in prices in 2003 to rises of 1.4 percent in 2004 and 2.4 percent in 2005 despite the effect of globalization proves that the cyclical process of emerging from the recession has an important effect on prices in the medium term. In particular, it appears that the surplus production capacity of previous years that served to lower prices continued to contract in 2005.

Turning to monetary policy in 2005, after continuing to reduce the interest rate at the beginning of the year, a process that started in 2003 and persisted in 2004 as well, the Bank of Israel kept the rate at the low level of 3.5 percent from March to October 2005. It did this in the absence of clear evidence of a build-up of inflationary pressure. The picture changed in the last quarter of the year: against the background of the Bank of Israel’s assessments of the probability that inflation would be above the upper limit of the target range in the course of 2006, it started to raise the interest rate, reaching 4.75 percent in February 2006.

In these conditions, the continued growth of GDP and demand in 2006, which would be reflected in further contraction of the output gap, is expected to lead to a further rise in the Bank of Israel’s interest rate. This scenario emerges from the assessments crystallizing in the capital market and among the professional forecasters: while forecasts of inflation in the next twelve months indicate a return to the middle of the target range, this will require a further increase in the interest rate.

Continued adherence to the fiscal targets––restricting the rise in government expenditure to 1 percent a year, maintaining a low budget deficit as planned, and persisting in the reduction of the government-debt/GDP ratio will help preserve the favorable financial environment that existed in 2005. Continued implementation of the planned structural reforms is also of importance, including changes in taxation in accordance with decisions taken by the government, reforms in the financial system, including the adoption of the system of market-makers for government bonds, launching repurchase agreements (Repo) and securitization transactions, as well as the reform of the payment systems by the introduction of a Real Time Gross Settlement (RTGS) system.

The major potential causes for deviation from the main forecast above are the possibility that the growth in the US and/or East Asia will start to weaken, the implications of which would be a weakening of Israel’s growth too; a change in the global financial environment that would lead to the withdrawal of capital from emerging markets, Israel among them; and the economic implications of the possible aggravation of the geopolitical situation. On the other hand, there is a high probability that significant quantities of long-term capital will continue to flow into Israel if the rapid growth in the high-tech industries persists.

target, support growth and employment long term, and preserve ifnancial stability The Bank of Israel will continue to monitor economic developments, and will act to achieve the price-stability.

* This report incorporates the Report on the Expansion of the Money Supply, in accordance with section 35 of the Bank of Israel Law, 5746– 1985. This is the case because in each month from July to December 2005 the money supply exceeded that in the preceding twelve months by more than 15 percent. The changes in the money supply are discussed in section IIc(iii) below.

Stanley Fischer         




In the second half of 2005 the Consumer Price Index (CPI) went up by a 1.9 percent (an annual rate of 3.8 percent), significantly faster than in the first half of the year (when the CPI rose by 0.5 percent, 1 percent annual rate). Thus in the whole of 2005 the index rose by 2.4 percent, in the upper part of the target inflation range of between one percent and three percent a year.


The strengthening of the US$ against the other major currencies, particularly against the euro, and the persistent rise of oil prices were the main immediate causes of the rise in the CPI in Israel in the period under review.


The economy's continued recovery from the recession, expressed in strong growth for the third consecutive year, was reflected by prices: companies did not absorb increased production costs but maintained a high level of profitability. Nonetheless, surplus capacity that still exists despite its reduction moderates the rise in wages, and thus prevents upward domestic pressure on prices.


The Bank of Israel cut the interest rate again in January and February, and then halted the process, holding the rate at the low level of 3.5 percent until September. This took place against the background of assessments that at this interest rate, inflation over a one-year horizon was expected to be at the middle of the price-stability target range.


During the third quarter indications of the creation of upward pressures on prices became evident, and these increased in number and strength in the last quarter. The NIS depreciated, and there were signs of continued rapid growth. Although inflation expectations and forecasts were close to the middle of the target range, they incorporated expectations that a rise in the interest rate was getting closer and closer, and the extent of the expected rise kept increasing. The probability of a rise in global inflation also increased due to the rise in energy and commodity prices. These developments supported a hike in the interest rate, and at the end of the year it stood at 4.5 percent.


In 2005 fiscal policy supported price stability both through the moderate increase in government expenditure while keeping the deficit level, enabling the public debt to fall, and via the direct effect on consumer prices of the cut in the VAT rate.


The NIS/$ exchange rate during the second half of the year was affected by global trends in exchange-rates and capital flows to emerging markets, inter alia. It was also affected by a number of domestic developments, some of which tended to weaken the sheqel, and others, to strengthen it. Among the former were the continued narrowing of the interest-rate differential, and the equalization of the rates of tax on investment abroad with those on domestic investments. Acting in the opposite direction were the surplus on the current account, privatization, and the attractiveness of investing in Israel's high-tech industries that gave support to nonresidents' direct investments in Israeli companies.

The full document, in PDF file -

Previous Inflation Reports:

   Inflation Report 2005 (January-June)
   Inflation Report 2004 (July-December)
   Inflation Report 2004 (January-June)
   Inflation Report 2003 (July-December)
   Inflation Report 2003 (January-June)
   Inflation Report 2002 (July-December)
   Inflation Report 2002 (January-June)
   Inflation Report 2001 (July-December)
   Inflation Report 2001 (January-June)
   Inflation Report 2000 (July - December)
   Inflation Report 2000 (January - June)
   Inflation Report 1999 (July - December)
   Inflation Report 1999 (January - June)
   Inflation Report 1998 (January - June)
   Inflation Report 1997