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Inflation Report 2008, January - March
Letter of the Governor, Professor Stanley Fischer
Bank of Israel Jerusalem
May 2008
The Inflation Report for the first quarter of 2008 (the period covered by this report) is submitted to the government, the Knesset and the public as part of the process of monitoring 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 current report is the first of the new, more concise, quarterly reports on which the Governor and the Senior Monetary Forum decided in summer 2007, after reviewing the features of Israel's inflation targeting regime. The increased frequency of the report and its focus on explaining monetary policy is intended to help improve the transparency of the Bank's policy and its communication with the public.
The CPI rose in the first quarter of 2008 by 0.1 percent, but in the twelve months to March 2008 it rose by 3.7 percent, higher than the upper limit of the price stability target range (inflation of 1 to 3 percent a year). The deviation from the target range was the result of exceptional price rises of 2.5 percent in the months June-August 2007 related to the weakness of the shekel at that time, and to the significant increase in food and energy prices, particularly during the last months of 2007. These prices rose in Israel because of their steep increases world wide, and fruit and vegetable prices also rose due to several weeks of frost in Israel last winter. These upward pressures on prices were moderated by the sharp appreciation of the shekel.
Economic uncertainty increased in the first quarter of 2008, both in the financial markets and with regard to real economic activity and inflation. This was due to the worsening of the global financial crisis, which had started in the area of subprime mortgages in the US and spread to other financial markets in the second half of 2007. At that time it was very difficult to assess the effect of the crisis in the US on Israel's economy. Specifically, it was not known to what extent real activity in the US would be affected by the financial situation, how successful other countries would be in maintaining a stable level of activity ("decoupling"), or the degree to which the slowdown in global growth would impact on Israel's exports and level of economic activity.
The indications in the period reviewed suggested the realization of a pessimistic global scenario: (1) The financial crisis became more severe--there were further big losses by large financial institutions, a large investment bank collapsed, and aid to the financial sector by authorities in the US and around the western world continued and even increased; (2) data on real activity and employment in the US and some other leading economies were disappointing, and assessments that the slowdown in real activity would be more severe than originally expected, that it would continue into 2009, and that the US economy would suffer a recession became firmer; (3) the US dollar weakened against the currencies of the advanced economies, partly due to the sharp cuts in the Fed interest rate and expectations of further reductions.
Against the background depicted above, the appreciation of the shekel gained momentum, mainly against the dollar, but also against the euro and other currencies. From the end of 2007 until the end of February 2008 the NIS strengthened against the dollar by 6.7 percent, and in the first two weeks of March by another 6 percent, to a rate of NIS 3.40 to the dollar. This appreciation of the shekel enabled inflation to decline steeply, due to the pass-through from the exchange rate to consumer prices, which, although it has weakened somewhat, still exists. In addition, the appreciation is likely to affect future inflation if it persists and has a negative impact on Israel's exports and real economic activity in Israel.
Whereas until the end of 2007 there were no indications of a weakening of current economic activity, in the first quarter of 2008 the first signs of some slackening became evident, particularly in the results of the Companies' Survey. In addition, in light of the global financial crisis there was concern that continued significant appreciation of the shekel and a serious adverse effect on exports could cause financial difficulties in Israel too, something avoided hitherto.
During February and March the Bank of Israel expected that upward pressure on prices in Israel would ease significantly, so that inflation would return to the target range in 2008 against the background of the strengthening of the shekel against the major currencies and expectations that the global slowdown would reduce the rapid rates of increase of international prices of energy and food, and as a result also of slower growth in Israel. In light of these assessments, the Bank of Israel cut the interest rate for March and April by half a percentage point each. This brought the rate down to 3.25 percent, its lowest level for very many years.
In March the Bank of Israel intervened in the foreign exchange market for the first time in eleven years: on 13 and 14 March, against the background of abnormal movements in the shekel exchange rate in the previous few days, the Bank purchased about $600 million of foreign currency on the market.
At about the same time, on 20 March, the Bank started implementing a program to increase the level of the foreign exchange reserves by about $10 billion in the next two years, by buying about $25 million a day on the market. This is a small amount compared to the average daily volume of trade in the market, about $2 billion, although the cumulative annual purchases are not small. The program, which had been drawn up in the course of the previous few months, is intended to adjust the level of Israel's foreign exchange reserves to the levels customary in comparable economies, against the background of Israel's rapid economic growth and its increasing integration into the global economy.
The monetary measures related to the interest rate and the foreign exchange market were taken on the basis of the assessment that inflation will return to the inflation target range in the second half of 2008.
To summarize: the advanced economies are undergoing a financial crisis, possibly the most complex one in the last sixty years, and there is a slowdown in real global growth. Israel has enjoyed four years of economic prosperity, largely thanks to a responsible and prudent macroeconomic policy and improved functioning of the business sector. As a result of its openness to international trade in goods and services and in the financial field, Israel's economy is affected by global developments, but it appears that the effects of the current crisis on Israel will be relatively moderate compared to most other economies.
The Bank will continue to pursue a policy aimed at maintaining price stability, and subject to that, to support growth, employment and financial stability. In that way monetary policy will contribute to sustainable economic growth.

Stanley Fischer

Governor, Bank of Israel

  The CPI rose by 0.1 percent during the first quarter of the year. This brought the rate of inflation for the previous 12 months to 3.7 percent, which exceeds the upper limit of the inflation target range (1-3 percent). This was primarily due to the increase in oil and food prices worldwide in recent years and the particularly high increases in the CPI during June-August of 2007 (2.5 percent) which resulted from the depreciation of the shekel. Therefore, the deviation of inflation from the target range appears to be temporary. According to most estimates, including those of the Bank of Israel, inflation (for the previous 12-month period) is expected to return to the target range during the second half of 2008, both because the indexes of last summer will no longer be in the calculation and the inflationary pressures that have characterized the past year will have weakened.
  Against the background of the global financial crisis, which began in the US sub-prime mortgage market and quickly spread to both real and financial markets worldwide, global growth slowed during the last quarter of 2007, especially in the US. The macroeconomic data indicate a continued slowdown also in early 2008 and, according to IMF estimates, global growth will slow during the next two years, particularly in the US where a recession is expected.
  During the quarter under review, the shekel strengthened significantly at a rate of 10.1 percent against the dollar and 7.2 percent against Israel's main trading currencies. The appreciation contributed to a drop in the CPI during the quarter through lower costs of imports; however, it appears that the pass-through is now weaker than it was in the past. It is possible that some import prices have not yet been adjusted to the low exchange rate out of fear that it will change direction and therefore the stabilization of the exchange rate at its present level implies disinflationary pressure. In addition, the appreciation hurt export profits at a time when exporters were already facing a slowdown in global economic activity. This is liable to also cause a slowdown in private consumption and investment.
  On 20 March the Bank of Israel announced its intention of purchasing $10 billion over two years, in order to raise the level of the foreign exchange reserves to the desired level. At this time, with the exchange rate so strong, adjusting the forex reserves, which had been planned for some time, is consistent with the Bank's price stability objectives and its support for real activity.
  During the second week of March, the exchange rate appreciated sharply. As a result of extraordinary movement of the exchange rate during two days in mid-March, the Bank of Israel intervened in foreign currency trading by purchasing $600 million on a one-time basis over that two-day period.
  As of the end of 2007, the global crisis had not led to a contraction of real activity in the local economy and GDP even grew at a faster rate than its potential, thus creating excess demand. This was not reflected in the cost of labor but apparently was one of the reasons that inflation exceeded its target since it allowed the rapid pass-through of world price increases, particularly those of food, to the Israeli consumer. In the first months of 2008, the basket of indicators, which tends to lead real economic activity, pointed to somewhat of a slowdown in the rate of growth.
  In January, the Bank of Israel interest rate was raised against a background of accelerating inflation, both actual and expected, and a number of indications of excess demand in the economy.
  During the months of March and April, the Bank of Israel interest rate was reduced by a total of one percentage point. The reduction was necessary in view of the accumulating evidence of the severity of the global crisis, the accelerated appreciation in the exchange rate and the drop in US interest rates, which created conditions that tended to moderate inflationary pressure. The reduction in the rate of interest is likely to moderate the effect of the global crisis on Israel's economic growth.
  The rate of growth is expected to reach 3.2 percent in 2008, which is less than in the previous year. This is due to the effect of the slowdown in growth of the major economies, the continuing rapid increase in commodity prices, especially oil, the fall in share indexes in Israel and abroad and the real appreciation of the shekel against its main trading currencies.
  In coming months, inflation is expected to remain above the upper boundary of the target range, due to the continuing increase in global commodity prices during the past quarter. However, according to the Bank of Israel's assessment, the stabilization of commodity prices later in the year together with the appreciation that has occurred in the exchange rate and the slowdown in global economic activity will be sufficient to gradually bring down the rate of inflation. Thus, within a year, inflation will be located slightly above the center of the target range. Given this assessment, it is expected that the Bank of Israel will maintain the interest rate at a relatively low level during the course of the year in order to offset the influence of the global economic crisis on local real economic activity.
  The risk of inflation is tending upward and is dependent on the intensification or change in direction of the major trends that are currently affecting inflation: an additional acceleration in world commodity prices, a transition to depreciation of the exchange rate or an increase in wages in the economy as a result of excess demand that will delay the return of inflation to the vicinity of the center of the target range. It is possible that this will necessitate an increase in the rate of interest during the course of the year. In contrast, a continuation of the appreciation in the exchange rate or the intensification of the global crisis will work to constrain inflation to the point where it may even drop below the target range.
1 The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, 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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