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The Inflation Report for the first half of 2007 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.
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In the first half of 2007 (the period covered by this report), the Consumer Price Index (CPI) rose by a total of 1 percent. The inflation rate (CPI) over the twelve months ending June 2007 was minus 0.7 percent, significantly below the lower limit of the target range of price stability (between 1 percent and 3 percent rise a year). Rapid economic growth continued, with employment rising and unemployment falling.
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The financial markets became more volatile in the first half of 2007, particularly the NIS/US$ exchange rate and the bond market, after several years of relative stability that had prevailed despite a series of shocks that could have undermined it. The upward trend in share prices and the increase in activity in the markets nonetheless persisted, with a rise in the volume of trading and new issues. The main factors behind these developments were the reforms in the domestic financial markets carried out over the last few years, fluctuations throughout the world--including the weakening of the dollar against most other currencies and the changing status of emerging markets in the international financial markets--and Israel's continued rapid real economic growth.
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The market reforms were aimed at increasing the participation of large-scale foreign investors in the domestic markets and boosting the development of non-bank financial intermediation. It appears that these goals are being reached, with a rise in capital flows into, from and within the economy.
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The volatility of the exchange rate caused fluctuations in the CPI too: inflation, viewed over the previous twelve months, was below the target range until May, but from mid-May and particularly in June the weakening of the shekel against the dollar and even more so against the euro returned the expected inflation environment to the middle of the target range, and possibly even close to its upper limit.
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In the last two years Israel's inflation has been affected by conflicting forces. Both real economic growth and the fall in unemployment exert upward pressure on inflation; by contrast, the considerable current account surplus and the inflow of long-term capital tend to strengthen the shekel and to hold inflation down. It is difficult to assess the relative strength of these opposing forces or their overall effect on inflation at any point in time.
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The continued appreciation of the shekel since August 2006, and in particular in April 2007, caused the CPI to fall, and prompted the Bank of Israel to reduce the interest rate gradually to bring inflation back into the target range. The cuts in the Bank of Israel's interest rate widened the differentials between the policy rates in Israel and the US and the other advanced economies, and resulted in a change in the path of the exchange rate in May, and in June the shekel weakened even faster. The impact of the exchange rate (of the shekel against the dollar) on inflation in Israel is closer even than that in other small open economies, in large part because the link between domestic prices of important non-tradables--particularly housing and rents--are specified in dollars, although paid in shekels. Thus a change in the dollar exchange rate has a substantial impact on the inflation rate within a period of a few months.
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Despite the difficulty in hitting the targets precisely, the inflation targeting regime in Israel plays a decisive role in keeping long-term inflation in the low single digits. This, thanks to the existence of a clear target and the transparency of the central bank's interest rate policy that has succeeded in keeping inflation expectations around the center of the target over time. This stability, combined with fiscal discipline and a gradual well-planned process of structural reforms in the economy, has maintained an environment favorable to business activity, and has enabled sustainable growth to be maintained in its fifth successive year.
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At the time of completing this report, the assessment of economic developments in the next year remains positive--persistent high real economic growth, surpluses in the current account, expectations that the inflation target will be attained, and financial buoyancy.
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Nevertheless, at the time of writing (the end of July) we detect a certain deterioration in the balance of risks facing the economy, due particularly to concern over the continuation of stability in the international financial markets, for example in the markets for sub-prime mortgages and the consequent deterioration of credit conditions, to the difficulty in adhering to the strict framework of government expenditure as set out in the multi-year budget, and to geopolitical uncertainties. These risks accentuate the importance of sticking to a stable and transparent monetary policy regime that constantly strives to achieve the inflation target.
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Stanley Fischer
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Governor, Bank of Israel
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