Final version: 3.8.2010
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Inflation Report 2010, April–June
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
August 2010
This Inflation Report, covering the second quarter of 2010, is submitted to the government, the Knesset and the public as part of the process of assessing the inflation rate in relation to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate. The CPI rose by 1.6 percent in the second quarter of 2010, mainly due to seasonal factors. The CPI excluding the seasonal components––fruit and vegetables and clothing and footwear––rose by 0.7 percent. The housing component, which reflects the price of housing services by means of apartment rentals, increased by 2.3 percent in the second quarter, faster than the other components. The rate of inflation over the previous twelve months moderated in the second quarter to 2.4 percent, after a lengthy period in which it was close to or even above the upper limit of the target inflation range.
In the first quarter, the recovery in real global activity and world trade continued, led by the U.S. and the emerging market economies, while growth in Europe was slower. Against the background of the lower than potential level of activity and relatively high unemployment rates, the global inflation environment remained low. The fiscal debt crisis in several countries, mainly in South Europe, became more severe in the second quarter, leading to a significant rise in the level of uncertainty in the financial markets around the world, including Israel’s. This was most notable at the beginning of the second quarter, until the EU and the IMF announced the availability of funds to assist countries in financial difficulties in the euro zone, and until these countries started to tighten fiscal policies to deal with the crisis. These halted the decline in the financial markets, but the level of uncertainty remained high. Economic activity in Israel continued to expand in the second quarter, although some of the indicators relating to that quarter point to a slowdown in the rate of expansion. Available data indicates that although domestic demand continued to grow, the increase in exports, which are affected directly by developments around the world, slowed. The recovery trend was also evident in the labor market, with a decline in the rate of unemployment and an increase in the real wage.
The fiscal crisis in some European countries is likely to have an impact on Israel’s economy due to its potential effect on the demand for Israel’s exports and the effect on Israel’s capital markets due to its close links with financial markets around the world.
The shekel appreciated in both nominal and real terms during most of the second quarter; however, in mid-June the trend reversed, and the shekel depreciated until the end of the quarter and in July. Purchases of foreign currency by the Bank of Israel in April and May served to moderate the appreciation of the shekel in those months. In June the Bank of Israel did not intervene in the foreign currency market.
The Bank of Israel’s monetary policy in the second quarter was set in the framework of the process of returning the interest rate to a normal level appropriate to the economic conditions and the inflation environment. At the same time the heightened uncertainty regarding the global economic situation and its effect on Israel’s economy was reflected in a slowing of the pace of increases in the interest rate in the second quarter. The Bank of Israel interest rate was increased by 25 basis points in April 2010 to 1.5 percent, and was left unchanged until July. For August the interest rate was increased by 25 basis points to 1.75 percent. The downward trend in inflation, measured over the previous twelve months, towards the midpoint of the inflation target range, the increased uncertainty about the rate of Israel’s economic recovery later in the year, and the expectation that the major central banks around the world would leave their interest rates at low levels for a considerable time, all lent support to the decision to leave the interest rate unchanged in the second quarter.
To moderate the continued steep increase in housing prices at the beginning of 2010 and the rapid growth of housing credit, affected among other things by the low rate of interest, and to support financial stability, the Supervisor of Banks issued a directive which went into effect on July 1, instructing banks to investigate their housing credit closely, and requiring an additional provision for housing loans with a high loan-to-value ratio. This step is in accord with the approach that in order to implement the central bank’s policy, macroprudential tools should be employed in addition to the usual monetary instruments, to deal with issues related to financial stability. The use of such tools enables a more focused effect than can be achieved by changes in the interest rate, which have broader implications for the economy as a whole.
The inflation rate in the next twelve months is expected to be in the upper part of the inflation target range, and growth is expected to be slightly below 4 percent, so that the negative output gap will contract a little. Nevertheless, due to uncertainty about the development of the crisis in Europe and its effect on the global economy and on Israel’s economy, economic activity and inflation may deviate significantly from the forecasts. The development of housing prices in the near future is also expected to affect the inflation rate.
The Bank of Israel will continue to monitor developments in Israel and world wide and will act to maintain inflation within the target, while supporting real economic activity and the maintenance of financial stability. The path of the interest rate will continue to be determined in accordance with the inflation environment, the situation in Israel’s economy, global developments, including the path of global interest rates, and developments in the exchange rate of the shekel.
The Knesset passed the new Bank of Israel Law in March 2010, and it became effective in June. The new law provides the legal basis for the independence of the Bank of Israel, by clearly defining the Bank’s objectives, its functions, its decision-making methods, and the tools the Bank can use for achieving its objectives and how they can be operated. The Law sets the maintenance of price stability as the main goal of the central bank , together with the support of other objectives of the Government’s economic policy and the support of the stability of the financial system When the Monetary Committee is appointed in accordance with the Law, monetary policy decisions, including decisions on the interest rate, will be made by the Committee.

Stanley Fischer

Governor, Bank of Israel

  Inflation: The CPI rose by a cumulative 1.5 percent in the second quarter of 2010 (the period reviewed in this Report). Much of the increase in the index was due to seasonal price increases––mainly in the fruit and vegetables and clothing and footwear components of the index. The CPI excluding those items rose by 0.7 percent. The annual inflation rate dropped in the course of the quarter, and in June it was 2.4 percent––within the inflation target range. Inflation expectations for all terms showed slight increases, and remained in the upper part of the target range.
  The global economic environment: The fiscal debts crisis became more severe in the quarter reviewed, leading to an increase in the risk level in the financial markets, and a slump in prices of financial assets. The deterioration led to the European Union (EU) and the IMF announcing an aid package for countries with debt crises. This had the effect of halting the drop in asset prices, but the level of uncertainty remained high. The global economic recovery continued in the second quarter, but not uniformly: the rate of recovery in the U.S. and in the emerging market economies was higher than that in Europe.
  Real activity: In the first quarter of 2010 Israel’s economy continued to recover, based on increases in private consumption and exports, and the negative output gap contracted. Indicators of activity in the second quarter point to a slowdown in the rate of recovery against the background of the slowdown in exports.
  The exchange rate: Exchange rate developments in the second quarter were not uniform. At the beginning of the quarter the nominal effective exchange rate showed shekel appreciation, against the background of the weakness of the euro, the surplus in the balance of payments and the interest rate differential between Israel and other countries. In this period the Bank of Israel continued to intervene in the foreign currency market when the shekel appreciated exceptionally. The trend reversed at the end of the quarter, and the nominal effective exchange rate reflected sharp depreciation of the shekel. During the quarter there was moderate depreciation of the shekel, in terms of the nominal effective exchange rate.
  The financial markets: Prices of financial assets in Israel dropped markedly in the second quarter, against the background of growing severity of the fiscal debt crises in Europe. At the same time financial risk increased, and investors switched to safer investment channels. As in the financial markets in other countries, in Israel too the fall in prices of financial assets halted in June, but uncertainty remained at a high level.
  Monetary policy: : In the quarter under review the Bank of Israel continued with the adjustment of the pace of monetary expansion to the rate of economic recovery, intended to entrench the rate of inflation firmly within the target range, and to contribute to the continuation of the recovery while supporting financial stability. Against the background of the deterioration in the fiscal debt crisis and the consequent developments, the pace of increases in the interest rate was reduced in the second quarter. The interest rate for April was increased by 25 basis points to 1.5 percent, and was kept at that level from May to July. The rate for August was increased by 0.25 percentage points. In light of the rapid rise in house prices, and since most indicators justified leaving the interest rate at a low level, the Bank of Israel introduced macroprudential measures to deal with the rise in housing prices because of its potential effect on the stability of the financial system.
  The Bank of Israel forecast: The Bank of Israel assessment is that inflation in the next twelve months will be about 2.6 percent. The effective shekel appreciation in the last few months and the negative output gap that still exists––the effect of the global crisis on economic activity in Israel––will help to restrain inflationary pressures. The Bank’s assessment of growth in Israel in 2010 is 3.7 percent, and in 2011, 4.0 percent, so that the output gap will narrow in those years. The unemployment rate is expected to continue to decline moderately. These forecasts are expected to be realized along with the gradual process of increases in the Bank of Israel interest rate.

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