Preliminary translation: 30.1.2007
Final version: 14.2.2007
The full document, in PDF file -

Inflation Report 2007, July - December
Letter of the Governor, Professor Stanley Fischer

Jerusalem, January 2007

The Inflation Report for the second half of 2006 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 target set by the government. The Report was prepared in the Bank of Israel under the auspices of the Senior Monetary Forum, headed by the Governor, the Forum in which the Governor makes decisions on the interest rate.

In the second half of 2006 the Consumer Price Index (CPI) fell by 1.7 percent. Measured over the previous twelve months, the CPI at the end of the year showed a decline of 0.1 percent, below the lower limit of the target range of price stability (between 1 percent and 3 percent rise a year).

In the second half of the year, and indeed in the whole of 2006, Israel's economy benefited from several important achievements-a high rate of growth, financial stability, and low inflation-despite external events that could have undermined them, chiefly the war in the north in the summer. After the first half of 2006 when the rate of price increase, measured over the previous twelve months, exceeded the upper limit of the inflation target, the Bank of Israel pursued a monetary policy directed towards gradually returning the inflation rate to within the target range.

The overshooting of the inflation target in the first half of the year was due mainly to the weakness of the shekel against the dollar from June 2005 to February 2006-partly resulting from geopolitical events and the strengthening of the dollar world wide-and to the global rise in energy prices. At that time the Bank of Israel raised the interest rate gradually, in line with its policy aimed at achieving the inflation target. At the beginning of the year the Bank expected its policy to bring the rate of price increase back into the target range around mid-year, and that indeed happened. In cases of deviations from the inflation target, the Bank's flexible approach to inflation targeting aims to return inflation gradually to within the target range. This is to prevent unnecessary fluctuations in the economy generally and in the financial markets in particular, and to enable the effect on the markets and on the prices of goods and services of each change in the interest rate to be examined in the light of constantly changing conditions. In 2006 the main such changes were the fluctuations in the exchange rate of the dollar and in oil prices. The main purpose of the rise in the interest rate at the end of July was to maintain financial stability, against the background of the Bank of Israel's assessment at that time of considerable uncertainty as to the effect of the war in the north on the economy as a whole and on the markets.

In the last four months of the year the sharp fall in energy prices and the appreciation of the shekel against the dollar put downward pressure on the prices of goods and services. The appreciation of the shekel against the dollar can be attributed to the weakness of the dollar in the international markets and also to the robustness of Israel's economy, reflected in part by a large surplus in the current account of the balance of payments and by large capital inflows. The result was a cumulative drop in the CPI from September to November (inclusive) of 1.8 percent, which caused the index to undershoot the inflation target. The intensity and the speed of the forces affecting prices were not expected. In reaction to this development, the Bank of Israel started reducing the interest rate gradually from November, with the purpose of returning the rate of inflation gradually to within the target range, but just as the Bank had avoided steep interest rate hikes in the first half of the year, at this time too it avoided overly steep cuts in the rate. According to the Bank of Israel's and private forecasters' assessments, monthly inflation is expected to return to the seasonal path consistent with the middle of the inflation target range at the end of the first quarter of 2007. Nevertheless, as a result of the sharp price reductions at the end of 2006, inflation calculated over the previous twelve months is expected to remain below the target range until those reductions drop out of the calculation, in other words, until the last quarter of 2007.

The economic forecasts for 2007 remain positive. Rapid GDP growth and the decline in unemployment are expected to continue, as are price stability and financial stability. This view is based on the assessments that economic activity and world trade will continue to grow, and also on the Knesset's approval of the budget, which is appropriate to the macroeconomic situation.

However unexpected events during the year could cause the inflation path to deviate from what is currently anticipated. A renewal of sharp fluctuations in oil prices, a slowdown in growth globally or in the US, and a change in Israel's geopolitical situation are just three examples of such possible changes. The implementation of the planned reforms in the money market (for instance developing a market for Repo transactions) and in the payment and settlement systems, as well as the privatization of Haifa Oil Refineries-all of which constitute important steps in the promotion of medium- and long term economic growth-could cause some fluctuations in the interest rate in the short term. The Bank of Israel monitors economic developments so that it can continue to operate interest rate policy such that with a twelve-month horizon the interest rate will be appropriate for the achievement of the inflation target.

Stanley Fischer         




In the second half of 2006 the Consumer Price Index (CPI) fell by 1.7 percent, after rising by 1.6 percent in the first half. Over the whole of 2006 the index fell by 0.1 percent, below the lower limit of the price-stability target (of 1-3 percent inflation a year).


The main reasons for the drop in prices in the second half of 2006 (the period reviewed) include the continued trend of shekel appreciation vis-?-vis the dollar, and the sharp decline of world energy prices. Acting in the opposite direction were upward pressures on prices, deriving from the rise in domestic demand.


The strengthening of the shekel against the dollar, which had started in the second quarter, outweighed the other factors, and resulted in a drop in the prices of housing and tradable goods, and hence in the CPI.


From July to October the strengthening of the shekel was due mainly to long-term domestic factors, such as the continued firming of the economic fundamentals, including the credibility of macroeconomic policy, that boosted the inflow of capital to the economy. The appreciation of the shekel towards the end of the year, however, resulted mainly from global developments-the dollar's weakness in the international markets.


Economic growth continued in 2006, despite a temporary slowdown due to the war in the north. This growth was concomitant with a persistent narrowing of the output gap, although the increase on the demand side went together with an increase on the supply side, so that the growth had only a moderate effect on prices. The stability of the index of unit labor costs that resulted from parallel rises in labor productivity and the nominal wage provided evidence of the lack of inflationary pressure from the labor market.


The financial markets (foreign currency and domestic bonds) showed steadfastness throughout the second half of the year, despite the war in the north. At the outbreak of the hostilities the exchange rate weakened temporarily and the risk indices rose; at first there was a sharp fall in share price indices, but the markets soon reverted to their pre-crisis trends.


Monetary policy in the second half of 2006 reflected the change in the economic and security environment. Early in the period reviewed, when the Bank of Israel assessed that the forces acting to boost inflation still presented a threat, and Israel's sovereign risk premium was expected to rise, the Bank increased the interest rate by 25 basis points. As the months passed, with the appearance of domestic and global forces acting to reduce prices, the Bank of Israel cut the interest rate by a total of one percentage point, and at the end of the year the rate stood at 4.5 percent.


The expectation that the budget deficit would be lower than that originally planned despite the extra expenditure incurred by the government due to the war in the north, together with government decisions regarding the targets for the 2007 budget, and negative government borrowing, all these boosted the credibility of fiscal policy, and thereby contributed to the stability of the financial markets and prices.

Israel's monetary regime: The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, which since 2003 has been defined as an inflation rate of between 1 percent and 3 percent a year. (For details see Box 1 on page 11 in the Bank of Israel Inflation Report No. 17, July-December 2005.)

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