Preliminary translation: 4.2.2008
Final version: 20.2.2008
The full document, in PDF file -

Inflation Report 2007, July - December
Letter of the Governor, Professor Stanley Fischer
January 2008
The Inflation Report for the second half of 2007 (the period covered by this Report) 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 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 CPI rose in the second half of 2007 at an annual rate of 4.9 percent, and in the twelve months to end-December 2007 by 3.4 percent, higher than the upper limit of the price stability target range (of 1 to 3 inflation percent a year). The growth in GDP and employment, particularly in the business sector, continued throughout 2007, especially in the second half of the year, and unemployment fell. Many industries participated in the growth, and it was very evident in investments, private consumption, and exports. The current account of the balance of payments showed a significant surplus again in 2007, and foreign direct investment (FDI) in Israeli companies persisted, indicating investors' assessment that Israel's economy will continue to thrive. The financial markets' assessments of the robustness of Israel's economy were reflected in the improved credit rating granted by the Standard and Poor's rating agency, and by the invitation of the OECD to Israel to begin the accession process leading to membership of the organization.
The two main forces that exerted pressure on inflation in Israel in opposite directions in the last few years continued to do so in 2007: on the one hand, sustained rapid growth of economic activity that creates upward pressure on prices, and on the other, the trend of the strengthening of the shekel against the dollar that has persisted since early 2006 and that became even stronger in January 2008, that serves to moderate price rises. In 2007 prices were affected by another significant factor--the sharp increases in world prices of oil, other basic commodities and food. Although the pressure from domestic demand did not have a particularly marked effect on wages, it did enable producers to pass on to consumers the extra costs deriving from the increase in world prices.
Inflation in 2007 was highly volatile, as it has been in the last few years: in the first five months of the year the CPI rose by 0.3 percent, after falling by a total of 1.8 percent in the last four months of 2006. In June, July and August 2007 the index went up by a cumulative 2.5 percent, and in the last four months of 2007 it rose by a total of 0.6 percent. Most of the volatility of the CPI is still related to fluctuations in the NIS/$ exchange rate and to the very strong transmission mechanism from that exchange rate to consumer prices, a feature of Israel's economy for many years.
In the period reviewed the first indications of a weakening of the close connection between the shekel/dollar exchange rate and housing prices became visible. This was reflected both in a significant decline in the share of new rent contracts that were indexed to the dollar, and in a rise in the dollar price in contracts that were still indexed. It is too early to determine whether this is a passing development specifically related to the dollar's current worldwide weakness, or whether this signifies a genuine change in the public's behavior, that will persevere even if the dollar strengthens in the future.
The high volatility of price rises hinders monetary policy in performing its role of keeping inflation within the target range over a twelve-month period, and inflation deviates from the target quite frequently. Nevertheless, price rises viewed over a relatively long period, two years or more, were mainly within the target range. In addition, the public's inflation expectations, both short-term and long-term, calculated from various sources have stayed well within the target range. It may thus be claimed that an inflation targeting regime supplies an anchor for a low inflation environment, which provides a basis for setting prices in the economy.
Another important development in the period covered by this report was the financial crisis in the advanced economies, which has not yet run its course. The crisis, that started in the subprime mortgage market in the US, spread in a short time to other advanced economies and to several segments of the financial markets. Till now the crisis has had a relatively limited direct effect on Israel's financial entities. It is generally anticipated that the financial crisis will constitute a major cause of a slowdown in economic activity in the US. The longer and more severe that slowdown, the stronger will be its effect on the global economy, including, to a certain extent, economic activity in Israel. Nevertheless, the range of indicators on Israel's economy have not yet pointed to any significant signs of such effects, including forward-looking indicators (such as the Companies Survey, information derived from financial transactions, assessments of active market participants). The composite state-of-the-economy index, for example, rose by more than 8 percent in 2007, with the rise in the fourth quarter of the year higher than those in the other three.
The resilience of Israel's economy in the face of the crisis hitherto is founded on a number of factors: (a) the business sector is growing, is becoming more efficient, and is profitable; (b) fiscal policy is keeping to a budget that is appropriate to the state of the economy; (c) monetary policy is striving for price stability and supports financial stability, which together provide a favorable business environment. The inflation targeting regime with free capital flows and a free-floating exchange rate enables the private sector to benefit from the many advantages of access to the international financial markets, and affords monetary policy greater flexibility in tailoring the domestic interest rate to the needs of the economy.
That said, the fact that Israel's economy is a small one, very open to trade in goods and services and to strong and fast capital flows means that macroeconomic policy makers do not enjoy the same degree of flexibility in operating policy instruments as do their colleagues in large economies such as the US and the eurozone. Hence the great importance of adhering to the policy rules set by the government, in both the fiscal and monetary spheres, rules that boost and preserve the confidence of the public and of domestic and foreign investors that price and financial stability will be maintained.

Stanley Fischer

Governor, Bank of Israel

  The Consumer Price Index (CPI) rose by 3.4 percent in 2007, above the upper limit of the price stability target of 1-3 percent inflation a year. In the first half of the year it rose at an annual rate of 2 percent, while in the second half (the period reviewed) at an annual rate of 4.9 percent.
  The CPI was affected in 2007 by the steep worldwide rise in energy and food prices, and by the rise in housing prices that occurred despite the appreciation of the shekel, against the background of increased economic activity and the contraction of surplus production capacity. The CPI excluding the energy and food components rose at a rate below the midpoint of the target range. The decline of the value of the dollar during the year (due to domestic factors and world trends) partially offset some of the upward pressures on prices.
  Energy and food prices rose faster and faster as the year progressed, and led to an acceleration in price rises in many countries. Thus the consumer price index in the US rose by 4.1 percent, and in Europe by 3.2 percent.
  Economic growth in Israel continued, with marked increases in private consumption, investments and exports. The number of employees rose by about 4 percent, with a decline in the unemployment rate to 7.3 percent, and the average wage rising by 2 percent. Unit labor costs increased in 2007, reversing the downward trend of the last few years--that had become flatter and flatter. The increase in GDP in 2007 derived from the rise in inputs, not productivity. These points indicate convergence to maximum utilization of the factors of production, and are likely to increase the upward pressure on prices.
  During the second half of the year the shekel appreciated against the dollar by about 9.5 percent, and by about 2 percent against the basket of currencies weighted according to Israel's foreign trade. There were two distinct trends in the NIS/$ exchange rate in the course of the period reviewed: sharp depreciation, that started in the second half of May, which reversed at the beginning of August to become a trend of rapid appreciation, which continued until the end of the period. Both trends were accompanied by increased volatility of the exchange rate.
  The strengthening of the shekel in the second half of the year was the outcome mainly of the weakening of the dollar world wide, which accelerated in August in light of the financial crisis in the advanced economies and its implications on the US economy. This took place against the background of the narrowing negative differential between interest rates in Israel and the US, the sustained improvement in the Israeli economy's fundamentals that contributed to the continued foreign direct investment (FDI) in the economy, and the current account surplus which despite some decline, is nevertheless expected to reach 3 percent of GDP.
  Following the process of interest rate reductions that began in the last quarter of 2006 and continued in the first half of 2007 in light of the low inflation environment, the Bank of Israel raised the interest rate in the third quarter of 2007 by a total of 0.5 percentage points, to 4 percent. The reason for the increases was the assessment that the inflation environment was rising, against the backdrop of sharp depreciation of the shekel against the dollar in May-July, the rise in world energy and commodity prices, and the continued rapid expansion of economic activity in Israel.
  The interest rate remained unchanged in the last quarter of 2007, the result of assessments regarding the conflicting forces acting on the inflation environment. On the one hand, there were upward pressures on prices, headed by the rise in world prices of energy and commodities and continuing economic growth. Acting in the opposite direction were domestic forces tending to strengthen the shekel, global factors weakening the US dollar, and concern over the effects of the financial crisis on the global economy. In December, when upward pressure on prices became more intense, the Bank of Israel again raised the interest rate by 25 basis points, bringing the rate for January to 4.25 percent.
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