1. Introduction
I would like to begin today by considering the focus of monetary policy on attaining the inflation targets set by the government for 2001 and the subsequent years, pointing to four main principles behind the process of determining the interest rate.
I will then contend that one of the main advantages of the monetary policy focus on attaining the inflation targets is that it enhances the economy's ability to withstand shocks of various kinds, i.e., it makes it more resilient. That is why it is extremely important to continue with this policy in the future, too.
Finally, I will attempt to assess the disparate forces affecting our estimates of inflation for next year and the following ones, along with monetary policy and the forces with which monetary policy has to reckon. In this context, I will emphasize the need to maintain budgetary discipline in 2001 as part of the macroeconomic policy aimed at establishing an infrastructure for sustainable growth.
2. The focus of monetary policy on inflation targets: description and principles
The government has set inflation targets for 2001, 2002, and 2003 of 2.5-3.5 percent, 2-3 percent, and 1-3 percent respectively. After 2003 the inflation target will not change as it is defined as price stability. Israel will thus join a large number of countries that have adopted price stability as part of the basic standard of proper macroeconomic management, where the role of monetary policy is to focus on maintaining price stability.
Diagram no. 1 shows the path of the inflation targets for the next few years. Its declining trend reflects the outlook of the monetary policy to which I will presently refer. The diagram also presents the curve of inflation expectations in 2001 as derived from the capital market (the difference between Shahar unindexed bonds and CPI-indexed bonds for terms of up to seven years). As the diagram shows, inflation expectations in 2001 and 2002 are below the lower limit of the target, and as long as that is the case the Bank of Israel is justified in gradually reducing its key interest rate.
In the context of interest-rate policy it is important to understand the four main principles on which it is based. First, note that the Bank of Israel does not have an agenda of its own as regards the inflation targets. The interest rate is determined on the basis of the inflation targets set by the government, for each year, and especially with regard to the downward trend towards enduring price stability. Second, naturally the Bank of Israel administers the interest-rate policy with an eye to the future. Consequently, in making the monthly interest-rate decisions what is relevant is not information about past inflation but its implications for assessments of future inflation. Thus, the negative Consumer Price Indices of the last two months are not relevant in and of themselves for decisions about the interest rate, which inevitably affect future inflation. By contrast, assessments of future inflation, which are currently 2-2.5 percent, are relevant. Third, when attaining the inflation target for a specific calendar year conflicts with the disinflationary process, as is reflected in the declining path of the inflation targets set by the government for each year, it is the process rather than the calendar that takes precedence, namely, the disinflationary process itself prevails. This preference is the direct result of the forward-looking approach. Fourth, when the interest rate is reduced on the basis of the assessment that given the current interest rate future inflation will be below the inflation target, the Bank of Israel does its best to avoid changing the interest-rate trend, and that is why the interest rate is reduced gradually. This strategy is particularly important in an economy such as ours, where a low inflation rate is something of a novelty but the variance of the inflation rate continues to be high relative to most western countries (Diagram no. 2). Housing prices are still denominated in dollars, taxation and accounting are still adjusted for inflation, the national debt is still indexed to the CPI for the most part, and indexation is still extensive and automatic in regulations, legal provisions, and contracts. In this respect we differ from the US and other western countries, as we have a long tradition of high inflation rates. Consequently, the need to continue reducing the interest rate in order to bring it into line with lower inflation, and the importance of avoiding interest-rate zigzags in view of our long tradition of high inflation rates, make it necessary to reduce the interest rate gradually. In this connection, knowing where you're coming from determines the pace at which you can keep going.
3. The contribution of monetary policy to stability
A central characteristic of Israel's economy in 2000, and one which continues to feature prominently in 2001 too, is economic stability in several significant spheres, including prices and the foreign-currency market. This stability is notable in view of a series of events which, according to past experience, could have-but did not-upset it. These include exogenous economic events-first and foremost plummeting share prices on the Nasdaq-as well as endogenous ones such as uncertainty regarding the implementation of the reform of individual taxation (during 2000 and still prevailing), and securit unrest, which adversely affects mainly tourism, agriculture, and construction. All this is supplemented by a political situation that has been unstable for some time, culminating in the replacement of the government and ensuing uncertainty as to its economic policy.
Against this backdrop, the stability in the following spheres is remarkable: a. inflation expectations, which remain within a relatively narrow range of 1.5 to 3 percent (Diagram no.3);b. the exchange rate of the NIS has remained stable since the beginnig of 2000, and continues to vary by a negligible 0.3 percent against the currency basket, and a relatively low 3.5 percent against the dollar (Diagram no. 4). This stability is particularly notable when the variance of the exchange rate in several western countries is compared with ours (Diagram no.5), with the low probability of a shock due to depreciation of 10 percent or more (Diagram no. 6), and Israel's credit rating, which has remained steady despite the various events.
This stability, which should not be taken for granted, is no mere accident of fate. To a very great extent it is the result of the macroeconomic policy strategy at the center of which lies the fiscal and monetary policy delineated at Maastricht and which we have taken on board. This involves fiscal policy that till now has aspired to attaining a declining budget deficit geared to meeting the Maastricht criteria in 2003, gradually reducing the national debt that continues to constitute a burden, and monetary policy that aspires to attaining and maintaining price stability.
Recognizing the stability in the various spheres and the link between it and the policy strategies described above is important in view of recent statements to the effect that as a result of the economic slowdown it is necessary to adopt a policy of monetary and/or fiscal expansion. In our view, this could have an adverse effect on stability and hence on the efforts to help real economic activity to recover.
If, on the other hand, we do not look for short cuts and continue reducing the interest rate gradually we can continue to narrow the gap between the interest rates in Israel a abroad (Diagram no. 7), as well as reduce both the nominal and the real interest rates (Diagrams nos. 8 and 9).
4. The forces that will influence inflation in the future
Capital flows and the exchange rate: capital inflows are generally divided into those that are not sensitive to interest-rate differentials and those that are. The former involve direct investment and tradable securities portfolio investment, which reached a record $ 7 billion in 2000. Because of the fall in share prices in world stock markets in general, and in the Nasdaq in particular, levels are expected to be far lower in 2001 (e.g., the extent of IPOs to date this year is $ 2.2 billion, compared with $ 3.7 last year, Diagram no. 10).
As regards capital flows that are sensitive to interest-rate differentials, in recent months the difference between short-term interest rates in Israel and the US has risen to 2.2 percent, but in the long run (beyond 2001) it is reasonable to expect itto continue contracting, and hence to exert pressure for capital outflow.
In addition, we have relaxed the restrictions on foreign investment by institutional investors to some extent, so that capital outflow is expected from that quarter.
The current-account deficit is expected to be larger than it was last year because the demand for Israeli exports will decline as the growth rate of world trade slows from 2000 (from 10 percent to 7.8 percent, Diagram no. 11).
All these factors are expected to generate forces that will lead to local-currency depreciation, though it is not clear whether this will in fact happen. And if it does, will the passthrough from the exchange rate to prices be the same as the one we have experienced in the past? In this respect, in our view the following differences are relevant. First, the business sector, and to some extent households too, tend today to behave in a stabilizing manner, i.e., when there is depreciation they sell foreign currency, thereby moderating the trend. This is in contrast to the past when, as exogenous forces led to depreciation, the business sector and households also tended to buy foreign currency, thereby intensifying the forces and the depreciation, displaying
destabilizing behavior. Second, in the past, when the exchange rate was managed, local currency depreciation signalled a price rise, i.e., the passthrough from the depreciation to the price rise was rapid. The situation is very different in that area today, as it is now over three years since the Bank of Israel ceased to intervene in the foreign-currency market, and it is evident to everyone that depreciation may be followed by appreciation.
World prices; the assumption is that the extent of global economic activity in the west will serve to moderate the rise in world prices.
The effect of the slowdown on demand and through it on prices; in 2000 Israel's economy grew at an impressive rate-by almost 6 percent. The security unrest, decline in the extent of economic activity in the US and the world, and fall in share prices in the capital markets, and in the US in particular, are expected to cause our growth rate to slow this year-to about 2 percent. Together with the low growth rate, the unemployment rate is expected to remain high approximately 9 percent. Note, however, that despite the high unemployment rate there is still a shortage of workers in construction and agriculture, while the number of foreign workers has not fallen and continues to be high (Diagram no. 12).
It is reasonable to assume that the high unemployment rate will tend to moderate wage
demands, but note that the wage structure, especially in the general government sector, has not internalized the low-inflation situation. Wage increases deriving from automatic wage drift due to such components as seniority, the rate of annual promotions, etc. entail nominal wage rises that are not consistent with price stability.
The budget; the assumption is that the fiscal policy strategy will persist, and that the new government will adhere to the strategy that has prevailed in the last decade. Specifically, we assume that the declining path of the budget deficit, along with the aspiration to attain a deficit in 2003 that is in line with the Maastricht target, as determined by the previous government, will be maintained by the present one (Diagram no. 13).
It is very important to continue the strategy of fiscal policy described above, and not to
adopt an approach that advocates fiscal expansion during a slump. The point of departure for continuing to act in accordance with the declining deficit path is that in order for Israel to fulfill its economic potential it must be integrated within the global economy, which is characterized by the free movement of goods, services, and capital. Hence, in order to integrate well within the global economy Israel must always be competitive with other countries, not only as regards the goods and services it exports but also as regards other components, including such aspects as competitive tax rates on individuals and firms. Increasing government expenditure and the deficit means raising taxes in the present or the future-just the opposite of what is needed.
Furthermore, competitive tax rates are particularly important in a country such as Israel, where the leading industries currently and in the foreseeable future are in the high-tech field, whose activities can be shifted abroad with relative ease. There is already a danger
that economic activity will be moved abroad due to the heavy tax burden, and it is clear that this danger will increase if the tax burden is intensified in the future following fiscal
expansion. In addition, the closer connection that exists today between the capital markets and within them the stock markets-and the real economy means that it is difficult and perhaps impossible to gain even short-term achievements by expansionary
fiscal policy. This is because by their very nature the capital markets constitute a link between the future and the present on the basis of past experience. Given this state of affairs, the decision to diverge from the fiscal policy strategy against the backdrop of a large national debt and high tax rates could within a short period of time cause Israel's credit rating to drop, thereby making it more expensive to borrow abroad. In the current situation, the cost of a deviation of this kind would soon be felt. Consequently, what will restore the economy to a path of sustainable growth is not expansionary fiscal and monetary policy but macroeconomic measures, chief among them being reforms in various spheres-a subject that requires a session to itself.