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Inflation Report 2008, July-September
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
2 November 2008
This Inflation Report, covering the third quarter of 2008, is submitted to the government, the Knesset and the public as part of the process of periodic monitoring of the inflation rate 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 Consumer Price Index (CPI) rose by 2.0 percent in the third quarter of 2008, and in the twelve months ending in September 2008 by 5.5 percent, well above the upper limit of the price stability target range of 1-3 percent inflation a year. This, despite the fact that in the third quarter the prices of oil and food dropped sharply, against the background of the global slowdown in growth. Price increases in Israel over the last year were greatly affected by the increases in world prices of raw materials before the first quarter of 2008, in particular oil and food prices, and by the buoyant level of demand in Israel. The steep rise in prices in the quarter under review was largely due to the high 8.2 percent increase in the housing component.
In light of the rapid and persistent increase in prices since the beginning of the year, and assessments that Israel's economy was in a full employment situation, the Bank of Israel increased the rate of interest by 25 basis points in each month in the third quarter, and in September it stood at 4.25 percent.
In the last two weeks of the quarter the global financial crisis worsened sharply, and the deterioration became even more severe in the first week of October. This included the collapse of banking and financial institutions in the US, the UK and Europe, an increase in risks, and a credit squeeze; these led to a slump in the prices of financial assets throughout the world. Central banks and governments adopted various rescue plans and other exceptional measures with far-reaching implications for the structure of the markets and their functioning. The deterioration in the global crisis also affected Israel's capital market: uncertainty increased, growth expectations declined further, and prices of shares and bonds fell steeply.
In light of the sharp increase in uncertainty and the decline in expected inflation, in the discussion on the interest rate for October, which took place in the first week of the deterioration in the crisis, it was decided to leave the interest rate unchanged, despite the high rate of inflation (4.4 percent since the beginning of 2008) and the fact that the economy was close to full employment. As mentioned, the deterioration in the global crisis intensified, uncertainty increased further and prices of financial assets dropped faster also in Israel, albeit to a lesser extent, and there was concern that the situation in both the financial and real sectors would worsen. Therefore, given that the reduction in world commodity prices and the expected slowdown in domestic demand greatly eased concern over inflationary pressures, an inter-meeting interest rate decision was taken on 7 October, and the rate was reduced by half a percentage point, to 3.75 percent. The intention was, among other things, to raise the level of liquidity in the domestic financial markets. The day after the decision, a similar step (coordinated among them) was taken by the leading central banks--the Fed, the ECB, the Bank of England and others, which reduced their rates by half a percentage point. The Bank of Israel's decision did not raise inflation expectations for one to two years forward, and these stayed at the lower limit of the target inflation range. In addition, the Bank's interest rate decision halted the upward trend in the real yield to maturity on bonds to all terms (Galil bonds), which had accelerated with the worsening of the crisis. In light of the relatively low level of expected inflation, and with the intention of increasing liquidity in the financial sector and providing support for real activity, it was decided at the end of October, at the normal scheduled discussion of the interest rate for November, to reduce the interest rate by a further 25 basis points, to a level of 3.5 percent.
The trend of nominal and real appreciation of the shekel against other currencies continued in the third quarter (until the reduction in the interest rate). The Bank of Israel continued to buy foreign currency in the third quarter, and from 10 July, in light of the rapid cumulative appreciation of the shekel, it increased its purchases to $100 million a day. With the recent rise in uncertainty regarding the situation in the global economy, the Bank of Israel is considering continuing with its purchases of foreign currency even after the completion of its planned increase in the forex reserves.
The main objective of monetary policy is to preserve price stability while supporting economic growth, employment and financial stability. In a period of a global crisis of unprecedented magnitude, such as the present one, the advantages of a flexible inflation targeting approach stand out. Operating under that regime, when inflation deviates from the target range, the Bank of Israel acts to return it gradually to the range, in order to moderate the possible short-term impact on economic activity and financial stability.
According to the assessments of the Bank of Israel and other forecasters, the annual rate of inflation (the rate of price increase over the previous twelve months) in the near future is expected to remain above the target range, but to moderate gradually and return to within the range by the middle of 2009. The downward adjustment of inflation forecasts compared with those in the previous Inflation Report (in July 2008) resulted from the sharp fall in world commodity prices and the worsening of the global crisis beyond previous expectations.
The current period is one of uncertainty about economic developments in Israel: in particular significant risk factors relate on the one hand to inflation and on the other to economic activity. The main risk stems from the deteriorating and persistent global financial crisis. Here it should be noted that Israel is unlike many other countries in that its general financial system, and in particular its banking system, are well-placed to meet the global crisis. The Bank of Israel will continue to monitor the economic situation and assessments of expected developments around the world and in Israel, and will act to achieve price stability while supporting real economic activity and preserving financial stability.
It is possible that the situation will develop to the point in which steps by the government and the Bank of Israel supportive of economic activity may be required, but it is essential that such steps be appropriate to the targets and constraints of the medium and long terms. It is of special importance that such steps should not result in an excessive increase of the government deficit or government debt. In this context it should be noted that the relative resilience of Israel's economy in the face of the global crisis is in significant part due to fiscal responsibility in the last few years, reflected by the decline in the deficit and in the debt/GDP ratio. The anticipated slowdown in economic activity will cause a drop in tax revenues, which may be expected to temporarily increase the government deficit. The credibility accrued by fiscal policy, however, means that a short-term moderate increase in the deficit is not likely to undermine economic stability or the confidence of the public, domestic and foreign investors in Israel's economic policy. Nevertheless, as the ratio of public debt to GDP is still higher than the desired long-term level, care should be taken to avoid steps that would increase the deficit and the debt by more than required as a direct result of the slowdown--i.e., by more than the effect of the automatic stabilizers.

Stanley Fischer

Governor, Bank of Israel

  In September there was a significant worsening of the global crisis. As a result of the magnitude of the events that occurred since then, the last two weeks of the third quarter overshadow most of the quarter, i.e., the previous two-and-a-half months. Monetary policy in the third quarter (the period reviewed in this Report) thus divides into two periods. In the first, interest rate decisions were taken on the interest rate for the months of the third quarter, in light of expectations of a global economic slowdown that would have a limited effect on Israel's economy and inflation; in the second period interest rate decisions were taken for the beginning of the fourth quarter, following the deterioration in the global crisis and a revised assessment of the risks.
  The CPI rose by 2.0 percent during the third quarter of 2008. Inflation in the twelve months to the end of September 2008 was 5.5 percent, significantly higher than the upper limit of the price stability target of 1-3 percent annual inflation.
  The most important factor that contributed to the high rate of inflation in the third quarter was a sharp and unexpected surge in the housing component. This was unlike the development in the first half of the year, when the main elements contributing to inflation were the sharp price increases in the energy and food components, as a result of the increase in world oil and food prices in the last few years.
  The global financial crisis continued in the third quarter, and worsened dramatically, on an unprecedented scale, in the last two weeks of the quarter, with the collapse of large financial institutions. The deterioration obliged governments around the world to take several exceptional measures, incurring huge costs and with far-reaching implications for the structure of the markets and their functioning. Share and bond markets world wide reacted to the increased severity of the crisis with sales and redemptions, and sharp price falls. This financial crisis has implications for real global activity, and hence affects the inflation environment, as can be seen for example in the dive in oil prices.
  According to National Accounts data, activity continued to expand in the second quarter, albeit at a slower pace than in the period since mid-2003.
  Some of the data relating to the second quarter and preliminary indicators of the third quarter support the assessment that the slowdown in the rate of expansion will continue; this is mainly due to demand factors (the effect of the global crisis and real appreciation), but also due to supply factors (the full employment environment in the labor market).
  In terms of the effective exchange rate, the shekel strengthened slightly in the third quarter, a period with high exchange rate volatility. The Bank of Israel continued to purchase foreign currency, and at the beginning of the quarter it increased its rate of purchases from $25 million a day to $100 million a day.
  In the course of the quarter, inflation expectations and expectations of increases in the interest rate moderated, and this trend intensified in the last two weeks of the quarter, against the background of the global developments. At the beginning of the quarter inflation expectations were close to the upper limit of the inflation target range, and at the end of the quarter, close to its lower limit.
  The interest rate was increased in each of the months July, August and September, by 25 basis points, reaching 4.25 percent, against the background of the high inflation environment and in light of the increasing uncertainty regarding the timing and extent of the real economic slowdown. On 7 October, in an inter-meeting decision, it was decided to reduce the interest rate by half a percentage point, in reaction to the worsening of the global financial crisis and the fall in inflation expectations. Thereafter, the interest rate for November was cut by 25 basis points, to 3.5 percent.
  According to most assessments, including that of the Bank of Israel, inflation is expected to return to within the target range by the middle of 2009.
  In the third quarter the Bank of Israel, like many other central banks around the world, had to deal with the implications of the worsening of the global financial crisis and the expectations of a slowdown in growth on the one hand, and the high inflation environment on the other. It seems, however, that the downturn in economic activity is more gradual in Israel than in other advanced economies.
  In periods such as the present one with dramatic developments on an unprecedented scale, the advantages of a flexible inflation targeting regime stand out, a regime in which the Bank of Israel acts to return inflation to the inflation target range gradually.
* 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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