- The rate of price increases slowed significantly in the first half of 1998-from 7 percent in 1997 to 4-5 percent. This is less than the lower limit of the inflation target for 1998, and one that brings Israel more quickly than expected towards the government's long-term target of price stability as customary in the industrial countries.
- Alongside the decline in actual and expected inflation, there was a long-term reduction in the Bank of Israel's key interest rate, amounting to a cumulative 2.1 percentage points in the first half of 1998, and 5.7 percentage points from mid-1996. The rate at which the nominal interest rate was reduced was intended to maintain the relatively low inflation environment and reduce the risk of a shock to the foreign-currency market due to the narrowing of the nominal interest-rate spread between Israel and abroad, given the exchange-rate regime. The backdrop to this was the economic crises in East Asia and elsewhere. In the wake of the cautious reduction of the interest rate following the decline in inflation expectations, the expected real interest rate rose from an annual average of 5 percent in 1997 to 7.5 percent in the first half of 1998. The combination of a rise in the real interest rate with a rapid decline in inflation is not unique to Israel, and has also been experienced by other countries undergoing a similar inflation-reduction process.
- An important cause of the decline in inflation was the slower expansion of domestic demand. This slowdown was due to the combination of economic policy (both fiscal and monetary) and other factors, including the continued tapering-off of the expansionary effect of the initial absorption of immigrants, political uncertainty, and reasons connected with the business cycle. The decline in prices abroad also helped to slow down the rate of price-increases. Fiscal and monetary policy were both based on a long-term view that aimed at laying the foundation for sustainable growth. Fiscal policy maintained the declining trend of the budget deficit/GDP ratio, in accordance with a predetermined path, contributing to the marked reduction of the current-account deficit. In accordance with the government's decision, the object of monetary policy was to attain a rate of inflation in line with that customary in the industrial countries. Accordingly, and in view of the financial crises in East Asia and elsewhere, it was essential for economic policy to be guided by these aims. Alongside the reduction of domestic demand, growth slowed and unemployment rose. However, the latter was also due to the structural economic change Israel is undergoing, with the relative expansion of high-tech industries, which attract both capital from abroad and skilled labor, on the one hand, and the relative contraction of the traditional industries, with dismissals of employees who cannot easily find work in the expanding industries, on the other.
- The decline in world prices also created favorable conditions for slowing the increase in the CPI in 1997.
- The implementation of monetary policy intended to foster progress towards price stability, and the maintainance of fiscal discipline while improving the composition of expenditure to emphasize investment in the infrastructure and in human capital, as well as reducing public-sector involvement in the economy, constitute the key to sustainable growth.
The rate of price-increases slowed significantly in the first half of 1998-from 7 percent in 1997 to an annual rate of 4.5 percent. This rate is in line with an annual inflation rate that is below the lower limit of the inflation target for 1998 (7-10 percent), and could bring Israel's inflation rate into line with that customary in the industrial countries (in accordance with the long-term target set by the government, Appendix 1) albeit faster than planned. During the period reviewed, when the assessment that the 1998 inflation rate would be less than 7 percent became more firmly-established, the Bank of Israel refrained from acting to bring inflation up to the target rate. The object of this was to maintain the inflation environment at a lower level than in the past, given the government's decision to attain the price stability over time which constitutes the basis required for sustainable growth. This view is consistent with the importance attached by international markets to price stability, and has been publicly supported by the Prime Minister and the Minister of Finance.
Both the slower rate at which the prices of all the components of the CPI rose, and the moderation of inflation expectations, endorse the assessment that the inflation environment declined in the first half of 1998. A large part of the decline was achieved by means of an increasingly credible policy designed to lower the inflation rate, together with other factors (such as the decline in prices abroad) which also helped to slow the rate of price increases. Macroeconomic policy operated in the framework of the long-term approach intended to increase economic stability (slowing the rate of price increases and reducing the budget deficit). Tight monetary policy, alongside a fiscal policy of maintaining budget discipline, contributed to the moderation of the rise in domestic demand, and constituted an important element in slowing the rate of price increases. The slacker rise in domestic demand, accompanied by an increase in the unemployment rate, also derived from political uncertainty and the continued tapering-off of the expansionary effects of the influx of immigrants, as well as from structural factors that operated on the supply side and intensified the economic slowdown-the difficulty in the rapid transition of factors of production from the traditional industries to the expanding, high-tech ones.
The decline in the rate of price increases, to an extent that had not been expected, occurred within a relatively short time, so that ex post real interest rose, despite the cumulative 2.1 percentage point reduction of nominal interest since the beginning of 1998. The rise in real interest in the context of the relatively rapid decline in the rate of price increases is not unique to Israel; other countries in which a decision has been made to reduce inflation gradually have also experienced a rapid fall in the rate at which prices rose. The central banks of those countries have generally adopted a cautious policy in order to keep inflation low, doing so by adjusting nominal interest downwards slowly and carefully, bearing in mind the decline in actual and expected inflation. This policy was accompanied in these countries by a rise in real interest to relatively high levels for quite long periods, and in many cases by a rise in the unemployment rate, too. World experience shows that once the reduction of inflation is maintained growth resumes. The path of the Bank of Israel's monetary policy reflects the view that a cautious approach must be taken in reducing the nominal interest rate in order to maintain the achievement of lower inflation. Cautious reduction of interest rates reduces the instability and excess volatility in the foreign-currency market that results from the reduction of the nominal interest-rate spread between Israel and abroad, taking the crawling band policy into account. This is particularly the case in view of the crisis in East Asia.
In the wake of the rise in real interest rates in Israel, and in view of the adherence to fiscal discipline, a public debate has developed regarding the effect of this policy on unemployment. While tight policy contributes to the reduction of demand and slowing of economic activity in the short run, the long-term solution for unemployment of the kind that has emerged in Israel does not lie in the more rapid reduction of interest or the expansion of the government expenditure/GDP ratio, which could imperil the stability that is essential for sustainable growth. Easing the tax burden (in GDP terms), while adhering to fiscal discipline, and changing the composition of government expenditure by placing more emphasis on investment in the physical infrastructure, human capital, and R&D will help to reduce unemployment. Reducing the role of the public sector in economic activity, while continuing to intensify competition, will also contribute to attaining this aim.
In order to progress towards sustainable growth which reflects Israel's comparative advantage it is essential to attain price stability. Postponing the disinflation process could incur additional economic costs and will not prevent the need to reduce inflation in the future. International experience has proved that when the level and volatility of inflation are no longer a factor that affects the economic decisions of firms and households, this extends their financial and economic planning horizon and stimulates the investment, both internally and from abroad, that is crucial for sustainable growth. Attaining and maintaining price stability in the next few years will help Israel to integrate with the world economies, enhancing its economic stability and credibility as this is perceived by the rest of the world. This credibility is important inter alia for improving Israel's international credit rating on international financial markets, in view of the need to borrow abroad in order to finance investment and the import surplus. Moreover, in a small, open economy, a stable inflation environment at a level that is in line with that of its principal trading partners, contributes to reducing the uncertainty associated with the exchange-rate developments (Figure 1).
II. THE DEVELOPMENT OF INFLATION IN THE FIRST HALF OF 1998
(1) The Consumer Price Index
In the first half of 1998 the CPI rose at an annual rate of 4.5 percent, compared with 10 percent in the first half of 1997, and a total of 7 percent in 1997. The rate of increase of the CPI for the last 12 months is about 4.2 percent (Figure 2). The significant slowing of the rate of price increases has been evident since 1997:lV; in five of the months between 1997:lV and mid-1998 the CPI declined and its annual average rise was about 4 percent. The exceptional 1.4 increase in the CPI in April reflects mainly its seasonal path and the response of the residential housing index and other prices to that month's depreciation of the sheqel against the dollar. The slowing of the rate of price increases appears to reflect a change in the inflation environment, although the extent to which the new environment will persist depends on policy as well as on the underlying economic trends in Israel and abroad.
(2) The components of the CPI
The slowing of the rate of price increases extended to all the components of the CPI (Figure 3). With the exception of clothing and footwear, the prices of most of the components rose in line with the rate of change of the total CPI. The relative uniformity of the rate at which the prices of the various items rose bears out the assessment that there has been a decline in the inflation environment. The exceptional rise in the prices of clothing and footwear in the first half of 1998 was due mainly to seasonal factors; however, over the last 12 months their relative price has continued to fall. This occurred against the backdrop of the long-term process of exposure to competing imports. In the first half of 1998 housing prices, which constitute some 25 percent of the CPI, rose at a rate similar to that of the CPI adjusted for this item, thereby maintaining its relative price, after rising consistently in the last few years. This development reflects primarily the weakening of housing demand, for both residential and investment purposes, against the backdrop of several factors, including the marked decline in immigration, political uncertainty, the relatively high real long-term interest rate (which increases the cost of financing the purchase of an apartment), and the economic slowdown.
The rate of increase of the CPI adjusted for items which tend to be more volatile in the short run, also slowed significantly-to 4.5 percent in annual terms compared with over 8 percent in mid-1997. The prices of traded goods (excluding clothing and footwear) rose more slowly than those of nontraded goods (excluding fruit and vegetables) in the CPI. The wholesale price index rose by 3.4 percent in the last twelve months, slowing markedly already in mid-1996-before the slowdown in the CPI-and this could also serve as an indication of the weakening of inflationary pressures.
III. THE INFLATION ENVIRONMENT AND FACTORS AFFECTING PRICES
(1) The inflation environment
The inflation environment, which is assessed on the basis of various kinds of data, including a combination of actual inflation and the rate expected for the next year, sums up past and present inflationary forces. As regards the various factors described below, the inflation environment was lower in the first half of 1998 than in 1997, and remained below the lower limit of the target for 1998-closer to the long-term price stability target.
One of the main indicators of inflation for the next twelve months is expectations as derived from the capital market (on the basis of the difference between the annual yields on Treasury bills and CPI-indexed bonds). After the level of expectations in 1997 was within the target range, averaging 9.2 percent1, they began to fall steeply in December that year. Until June 1998 inflation expectations declined by 4 percentage points, from 8.2 to 4.2 percent. Despite the relatively steep rate of price increases in April, expectations continued to fall in May, apparently indicating that the public was making a clearer distinction than in the past between a one-off price increase and a rise in the inflation rate.
The decline in expectations in the period reviewed followed the fall in actual inflation, rather than preceded it (Figure 4), reflecting the adaptive component in expectations. Nonetheless, expectations adapt more rapidly when policy has greater credibility, as in fact occurred in the period reviewed. Note that reducing and stabilizing inflation expectations constitutes an important element of a policy that aspires to price stability, because expectations affect the rate at which prices actually rise. One of the principal mechanisms of this is wage agreements set in nominal terms and based to a great extent on the assessments by the parties involved of the expected rate of price increases during the period to which the agreements apply. The importance of this mechanism intensifies as the inflation rate approaches the cut-off point at which the Cost of Living Allowance (COLA) is paid.
1 On the basis of the gross yield on bonds.
The composition of the asset portfolio in the context of the public's assessment of the inflation environment
The readiness of the Israeli public to switch, albeit very cautiously, to unindexed assets indicates inter alia that it has greater confidence in the persistence of a low inflation environment (Figure 5). The attractive expected real yields on these assets in the period reviewed were the result of the faster decline in inflation expectations than in nominal interest, as well as of the continued internalization of the stabilization of inflation and its reduced volatility. In the first half of 1998 the proportion of unindexed assets in the public's financial portfolio continued to rise (to about 25 percent), and the proportion of CPI-indexed assets to fall (to below 50 percent).
The pattern of borrowing by the government, alongside the further decline in the relative yield on unindexed assets (vis-a-vis indexed ones), reflects its adaptation to the public's tendency to switch to unindexed assets, as well as its investment in developing nominal financial instruments. In the first half of 1998 Shahar and Gilon unindexed bonds were issued to an amount of NIS 5 billion, and there was substantial demand for them. Borrowing by the government by means of unindexed securities accounted for 55 percent of total, compared with 17 percent in 1994.
(2). Monetary policy and financial assets
Monetary policy affects the rate of inflation by determining the Bank of Israel's key interest rate and through various channels: interest rates in the money and capital markets, the narrow money supply (M1), the exchange rate, real demand, inflation expectations, and asset prices.
As noted in the previous Inflation Report, the Bank of Israel's key interest rate is set after a great many real and nominal indices have been analyzed. In the first half of 1998 the Bank of Israel continued reducing its key interest rate: within six months it has declined by 2 percentage points, to reach 11.3 percent in July (Figure 6). The gradual reduction of the interest rate was intended to put the achievement of reducing inflation on a firm footing, and take advantage of the opportunity to continue reducing inflation and attain the price stability customary in the advanced economies. Given the slope of the exchange-rate band, narrowing the gap between domestic and foreign nominal interest rates, which could lead to the reversal of the capital inflow, also requires caution in reducing nominal interest. In view of the considerable uncertainty on the international financial markets, and in East Asia in particular, the relative stability of the Israeli market is notable. The cautious monetary policy appears to have prevented wide fluctuations in the financial markets, especially regarding the exchange rate and capital flows and, within the context of stable economic policy, continued to reinforce investors' assessments of Israel's economic stability.
From mid-1996 to end-1997 expected real interest was some 5 percent, contributing to the reduction of inflation (Figure 6). From the beginning of 1998 nominal interest declined more slowly than inflation expectations, so that real interest rose gradually, to an average of 7.5 percent in the first half of 1998, compared with 5 percent in 1997. The experience of other countries shows that the process of reducing inflation from a two-digit to a one-digit level is generally accompanied by a rise in real interest for quite some time. The object of this is to establish a low and stable inflation environment. According to the experience of other countries, even if a temporary decline in economic growth is involved, growth resumes once the decline in inflation has stabilized.
The main instrument used by the Bank of Israel to continue managing the interest rate in 1998 was the auction for banks' time deposits with it. These deposits rose by NIS 6 billion in the first half of 1998-NIS 3 billion of it constituting the interest on them-to stand at about NIS 36 billion in June (compared with a NIS 20 billion increase in the equivalent period in 1997). The sharp decline in their rate of growth was due to the maintenance of fiscal discipline alongside the absorption of liquidity and the lack of any necessity for the Bank of Israel to buy foreign currency (except for a few days at the beginning of the year). Note that since the beginning of the year a new category of daily deposits has been added, quarterly deposits have been phased out, and most of the amount is concentrated in monthly deposits.
(b)The monetary aggregates
The effect of the interest rate on the narrow money supply (M1) is one of the channels by which monetary policy affects inflation, doing so with a lag of two or three quarters. As Figure 7 shows, there is usually an inverse relation between the Bank of Israel's key interest rate and M1.
In the first half of 1998 M1 rose by 9.3 percent (annual rate), less than in the equivalent period in 1997, and in the last twelve months it has risen by 11 percent. Given an expected inflation rate of between 4 and 5 percent, the rate at which M1 rose is slightly above the growth rate of potential nominal output (Figure 8). Nonetheless, the declining trends of nominal interest and inflation serve to increase the demand for money.
Information derived from the capital market is one of the main tools used by monetary policy-makers. One example of this is expected inflation, as described above, but there are also others. In general, the yield curves on Treasury bills and bonds, as well as the relative yields on fixed-interest and variable-interest bonds, indicated that in the first half of 1998 the expectation was that the inflation environment would continue to decline, and with it the Bank of Israel's key interest rate.
In the first half of 1998 the Treasury-bill yield curve fell significantly in comparison with 1997, to below 11 percent (10.3 percent in June) at long maturities (Figure 9). This decline reflected extensive demand for short-term Treasury bills throughout the period reviewed, indicating the public's expectations regarding the high real yield embodied in the nominal yield on Treasury bills. This was due inter alia to the persistence of the low inflation environment. The negative yield curve on Treasury bills appears to have reflected the expectations of economic agents that nominal interest would decline.
A comparison of the yield differentials on two unindexed bonds, Shahar and Gilon, serves as another indicator of the public's assessments of the Bank of Israel's expected interest-rate policy. The greater demand for Shahar (unindexed, fixed interest) than for Gilon (unindexed, variable interest) generally indicates investors' expectations that nominal interest would decline. Figure 9 shows the relative yields on these two bonds (for two years) and the relation between actual inflation and the inflation target. There is a positive correlation between the two variables, which is supported by statistical tests. In the first half of 1998 investors preferred Shahar to Gilon bonds, and this is consistent with the decline in the inflation environment to below the government's target for the year.
In the first half of 1998 there was a steep rise throughout the yield curve on CPI-indexed bonds, particularly at short maturities (Figure 10). The yields on 3-year bonds reached an average of 6.6 percent, and on bonds for longer periods (about 12 years) they were over 5 percent, compared with an average of 3.7 percent in August 1997, before the rise began. This trend was reflected by the rise in long-term bank interest, and particularly that on mortgages. The picture from the indexed bond market complements that from the Treasury-bill market, with a decline in the demand for indexed bonds as investors shifted to unindexed assets, indicating the public's assessment that the inflation environment would remain low. The negative slope of the yield curve on CPI-indexed bonds, which persisted throughout the period reviewed, reflected investors' expectations that real interest would fall.
At least two salient factors should have served to reduce the yields on CPI-indexed bonds in the period reviewed-the smaller issues of indexed bonds by the government and the economic slowdown, with the sharper contraction of investment than of savings-but their effect appears to have been weak, so that yields rose.
Since February 1998, in the context of the resurgence of the money markets in the industrial countries and despite the slowdown in the domestic market, Israel's share-price indices (and particularly the shares of industrial firms and banks) rose markedly, so that in the period reviewed the general share-price index has risen by 8.4 percent (Figure 11). The rise in share prices is not consistent with the economic slowdown, and may reflect investors' optimism regarding the longer run, when the process of economic stabilization (reducing the deficits and inflation) and the greater openness of the economy (liberalization of the foreign-currency market) will be reflected in renewed and sustainable growth.
Concurrent with the rise in share prices in the first half of 1998, there was an increase in turnover, in the context of a wave of purchases of Israeli firms, investment by nonresidents on the Tel Aviv Stock Exchange (TASE), and rise in the volume of privatization.
(3) The exchange rate and capital flows
The characteristics of the exchange-rate band, and the development of the actual exchange rate, play an important role in determining the path of price developments: the lower the rate at which the nominal exchange rate rises, the smaller the pressures for price rises. Similarly, the larger the role played by market forces in determining the exchange rate, the more freedom and effectiveness has monetary policy.
For most of the period reviewed the exchange rate remained near the lower limit of the band, whose slope was lowered from 6 to 4 percent in June 1997 (Figure 12). The reduction of the current-account deficit, together with the capital inflow (in view of the interest-rate spread between Israel and abroad, exchange-rate risk, and long-term investment), exerted downward pressure on the exchange rate in the first half of 1998, albeit to a far smaller extent than in the past. Nevertheless, no intervention by the Bank of Israel was required (except for a few days at the end of 1997 and the beginning of 1998) to defend the lower limit of the exchange-rate band.
The exchange rates against the currency basket and the dollar rose in the period reviewed, by 3.1 and 3.7 percent respectively, and do not appear to have constituted an inflationary factor. The exchange rate plus prices abroad rose at a slightly quicker rate than prices in this period, reflecting the tendency towards real depreciation (or the weakening of the trend towards real appreciation) in view of the slowing of domestic demand. Expectations of nominal depreciation2, as derived from the capital market until the end of 1997, were lower than expected inflation, but for a few months in the first half of 1998 the situation was reversed, so that expectations of real depreciation were indicated. Real depreciation together with a slower rate of price increases-the preferable kind of depreciation-makes Israel's exports more competitive without impairing nominal economic stability.
Depreciation accelerated in April, to 3.6 percent against the currency basket, in the context of uncertainty regarding the details of the plan to liberalize foreign-exchange control (particularly on the part of households, whose demand for foreign-currency-indexed deposits increased), but in May there was appreciation of 1.7 percent. Note that the accelerated depreciation of April did not affect the downward trend of either expected or actual inflation, except with regard to the CPI for April. This was because the public apparently tends to make a distinction between a one-off change in the level of prices and a rise in the inflation rate, especially since the depreciation may have been perceived as temporary. Under the current conditions, the influence of depreciation on inflation may no longer be as rapid as in the past, for a number of reasons: the greater volatility of the exchange rate, the economic slowdown, and the cost of updating prices. Allowing market forces to determine the exchange rate enables the risks inherent in taking foreign-currency credit for domestic activity to be better internalized, as is reflected inter alia by the higher premium on the Bank of Israel's NIS/dollar option.
Capital inflow of residents amounted to $ 1 billion in the first half of 1998, after capital outflow of the same amount in the second half of 1997. Foreign-currency-denominated credit extended to residents by the banks, amounting to $ 1.8 billion, was the main component of this inflow (Table 1). The $ 0.5 billion decline in foreign-currency-indexed credit offset some of this increase. Credit in and indexed to foreign currency expanded despite the trend towards the reduction of expected yield gaps. The increase in total foreign-currency assets (deposits denominated in and indexed to foreign currency, and futures) amounted to $ 1.3 billion, offsetting the increase in foreign-currency credit, so that the private sector's exposure to exchange-rate risk remained essentially unchanged.
The capital flow of nonresidents is notable for the rise in local-currency credit to finance their investments, easing the pressure to lower the exchange rate. As in previous years, there has been very little investment in bonds and deposits with local-currency yields by nonresidents in the first half of 1998. Nonetheless, in May this year nonresidents utilized for the first time a new local-currency channel-local-currency-denominated bonds issued on the euro market. The interest displayed by foreign investors in the new bonds fell below issuers' expectations, however, as reflected by the higher than expected yields. The reduction of the Bank of Israel's key interest rate, also reflected on the Treasury-bill market, contributed to making this channel less attractive. The decline in total investments by nonresidents relative to the first half of 1997 is also notable, principally in the wake of smaller offerings abroad by Israeli firms and the contraction of foreign direct investment.
In May 1998 the measures liberalizing foreign-exchange controls announced previously were introduced, so that almost all the restrictions on residents' transactions in foreign currency, and on nonresidents' transactions in Israel, were annulled (except for restrictions on derivatives transactions for longer than a month by nonresidents vis-?-vis residents, and restrictions on institutional investors). There have been no exceptional foreign-currency flows since then. This seems to indicate that responsible and credible fiscal and monetary policy can enable restrictions to be removed without causing a shock to the foreign-currency market. Nevertheless, the persistence of tax discrimination against investment abroad (by households) limits the effectiveness of the liberalization measures. Note that the liberalization process in and of itself has considerable potential to increase capital flows, increasing the country's vulnerability to irresponsible macroeconomic policy that is not in accord with international norms.
2 Expectations are derived from yield gaps between Treasury bills and Gilboa (dollar-indexed) bonds.
Although the risk premium cannot be deducted from the measurment the premium on the NIS/dollar option serves as an indicator of the risk premium.
(4) Fiscal Policy
The fiscal discipline to which the government has adhered since 1997, in contrast with the expansionary policy that preceded it, helped to moderate the inflation rate by damping domestic demand and reducing inflation expectations, as the policy became more credible. This discipline was required principally in order to bring the balance-of-payments deficit down to a sustainable level, thereby contributing to economic stability.
In accordance with its decisions, the government must attain the total deficit target (domestic plus foreign) of 2.4 percent of GDP by 1998, and continue to advance towards 1.5 percent of GDP by the year 2001 (Figure 13). Although the government's deficit target is defined in terms of the total deficit, the analysis of the domestic deficit is important as it is the relevant factor affecting domestic economic activity and inflation. In the first half of 1998 the budget deficit was NIS 3.0 billion (cash basis, excluding credit). An analysis of budgeted income and expenditure, in accordance with its seasonal path of the last few years, shows that on the expenditure side some NIS 3.7 billion was not utilized, explained mainly by the greater than expected slowdown in the rate of price increases, together with the decision to increase the inflation contingency reserve3 in the budget to 5 percent. Since there is a greater lag on the income side (deriving from a lower actual growth rate than was assumed in the budget and the shortfall in tax revenues), some deviation is expected from the planned domestic budget deficit in 1998, too, continuing the departure of over 1 percent of GDP in 1997 from the planned level of 2 percent of GDP. The effect on the budget of the public-sector wage agreements, which are due to be concluded soon, depends on the rate of wage-increases they involve.
Over and beyond the importance of attaining the deficit target, it is vital to reduce the tax burden, as well as to cut government expenditure and change its composition-diverting resources to investment in the infrastructure and in human capital-which will contribute to reducing the unemployment rate and restoring sustainable economic growth.
The government's net borrowing from the public in the first few months of 1998, by issuing bonds and selling assets to finance a large part of its deficit, (Figure 14), eased the task of monetary policy by limiting the need to deploy monetary instruments to absorb the excess liquidity deriving from the government injection, with its attendant costs.
3 The prise base in the budget derived from this decision
is 4.2 percent. Ministries may not increase expenditure beyond this without Treasury approval.
(5) Real Developments
Real economic developments in the first half of 1998 were characterized by the continued slow expansion of domestic demand and the rapid rise of exports, together with an increase in unemployment. The latter reflected the slowing of domestic demand beyond that of supply and, together with other factors, served to slow the rate of price increases. The main factors contributing to this trend were monetary and fiscal policy, the structural economic change taking place in Israel (which is expected in the long run to lead to stable, export-biased growth), the tapering-off of the expansionary effect of the influx of immigrants, especially on investment, and security-political uncertainty.
The GDP growth rate in 1997:lV and 1998:l was 1.2 percent (annual terms)-significantly below potential and reflecting a decline in per capita GDP. The rate at which business-sector product expanded also continued to moderate in that period (Figure 15). Particularly notable is the steep fall in investment, including investment in housing, due partly to the termination of the process of adapting capital stock to the level required by the mass immigration, but also influenced by the rise in real interest in this period and political uncertainty. In addition, tight fiscal policy was expressed in the reduction of public consumption (1998:l vis-?-vis 1997:l). Private consumption also moderated, at least in part due to the increase in the tax burden.
Alongside the significant slowing of domestic uses, exports-especially industrial exports (excluding diamonds)-grew relatively fast, up by 10 percent (nominal terms) in the first half of the year over the equivalent period in 1997, despite the crisis in Asia, which harmed exports to those countries. In volume terms, industrial exports were up by 5 percent in 1998:l over 1997:lV. This development is important for creating export-biased growth in the long term, which will improve the balance-of-payments on the current account. Increasing exposure to international markets helps to enhance the quality of Israeli products, thereby making the production process more efficient. Other than this, the composition of exports is consistent with the transition from traditional to high-tech industries, thereby bringing the economy nearer to GDP composition that reflects its comparative advantage (Figure 16). The deficit on the balance-of-payments on the current account was $ 0.5 billion in 1998:l, compared with $ 900 million in 1997:1, the decline reflected an improvement in the civilian import surplus as a result of the rise in exports and fall in imports.
The structural economic change that Israel is undergoing, characterized by the rapid growth of the high-tech industries and the contraction of the traditional ones, impairs the ability of supply to expand rapidly in the short run because it is difficult for factors of production, and the labor force in particular, to adapt to this change rapidly. Factors that operated to reduce the profitability of some industries-such as the cumulative real appreciation of the last few years, which has exceeded the long-term trend, the exposure to competing imports, relatively high real interest, the increase in the minimum wage, and the shortage of labor in the high-tech industries-also slowed the rate at which supply expanded.
In the wake of the economic slowdown, the unemployment rate has been rising persistently, from an average of 6.7 percent in 1996, to 7.7 percent in 1997, and 8.4 percent in 1998:l (Figure 17). The share of low-skilled workers among the jobless has risen, due partly to the contraction of the traditional industries (Figure 19), in line with the world-wide trend of the faster increase in demand for high-skill-intensive products.
Real wages were up by 3.8 percent in 1998:l over 1997:1 (a nominal rise of 9.5 percent). In the business sector real wages rose by 5.5 percent, and remained stable in the public sector. This may be because the rate of price increases slowed beyond the level expected at the time the wage-agreements were signed, the effect on the average wage of dismissals of employees earning a relatively low wage, the shortage of highly-skilled employees, and the rise in the minimum wage.
(6) External factors
The financial crises in East Asia in the second half of 1997, and the long-term damage to real economic activity in those countries, were reflected in the curtailment of Israel's exports to them, especially diamonds, in 1998:l. This was apparently because those countries' imports became more expensive in the wake of the devaluation of their currencies and reduction of their income. On the other hand, there was no significant change in imports from those countries even though they became cheaper (in dollar terms). International assessments are that it will take a long time for those economies to recover fully, so that it is impossible to tell at present what the long-term implications for Israel's balance of payments will be.
The import and export prices confronting Israel affect both domestic prices, via their influence on finished traded goods and raw materials, and real economic activity, via their effect on the relative worthwhileness of imports and exports. In 1998:l prices of merchandise imports fell by a further 3.4 percent (excluding ships and aircraft) compared with 1997:lV, continuing the downward trend in these prices evident since mid-1995 (Figure 19). Export prices declined by only 0.7 percent in 1998:l, so that Israel's terms of trade continued to improve. These price trends, together with other factors, helped to slow the rate of price increases in Israel and improve the balance of payments.
IV. THE BACKGROUND AND POLICY REQUIRED TO MAINTAIN LOW INFLATION IN ISRAEL
(1) Long-term inflation expectations
Long-term inflation expectations provide an indicator of the public's confidence in the persistence of the relatively low inflation environment. Expectations for the second and third years varied around 9 percent in 1997, and then began to decline during the period reviewed (Figure 20). This downward trend, from over 7 percent in December 1997 to 4 percent in June 1998, and the relatively flat curve of expectations reflects the public's assessment that inflation will stabilize at this low level in the years ahead, too. The level of expectations for three years-4.5 percent in June 1998-is higher than that for two years, and still above the long-term target of price stability. Nevertheless, the risk premium investors require on long-term unindexed yields should not be disregarded, so that expectations adjusted for the risk premium are apparently lower.
(2) The conditions for maintaining a low inflation environment
Setting inflation targets
Setting specific inflation targets for 1999 and the following years as soon as possible is necessary to maintain the government's commitment to price stability and pursue monetary policy that is responsible, transparent, and efficient. Note that already at the end of 1996 the government decided that the inflation target for each year would be determined by the middle of the preceding year. Setting an inflation target constitutes an announcement of policy objectives, helping all economic agents-whether in the public or the private sectors-to plan their activities, serving to stabilize inflation expectations, and thereby to reduce inflation and cut the costs involved in the disinflation process. Delay in determining the inflation target for 1999 and for the coming years impairs the ability to implement an efficient monetary policy, especially because of the lag in the effect of monetary policy on inflation. The target set must make it possible to maintain inflation at a low level and to attain long-term price stability, in accordance with the government's decision.
Attaining the government's deficit target is crucial for establishing the credibility of the process of reducing the rate of inflation and attaining economic stability over time-which is particularly necessary in view of the economic crisis in East Asia. Hence, even at a time of relatively moderate economic activity it is important to keep the implementation of the budget in line with the limits prescribed by law. In the framework of the budget for the coming year care should be taken to ensure that the prices on which it is based are in line with the inflation target that will be determined.
It is important to reduce the tax burden in order to increase the incentive to invest and work, thereby stimulating growth in the long run. The tax burden can be eased only by an appropriate reduction of the expenditure/GDP ratio, in order to prevent an undesirable deviation from the deficit-reduction path. In the process of reducing the deficit, the composition of government expenditure is very significant for improving the chances for economic growth. Diverting resources for infrastructure investment, which yields a high return, is crucial because of the contribution to both productivity and sustainable economic growth over time as well as to expanding real economic activity in the short term. Supporting and encouraging vocational retraining will help to reduce the unemployment rate by enabling some of the unemployed to find work in the expanding industries. Increasing current expenditure and transfer payments, which tends to be permanent, acts counter to the desired trend of reducing public-sector economic involvement, and is reflected by an increase in the government debt-making it difficult to maintain economic stability over time.
The public-sector wage agreements that are due to be concluded soon must internalize the budget targets, including those set for inflation. Since the agreements are signed for a period of more than a year, they must also be in line with the long-term path for reducing inflation. Setting explicit inflation targets for several years will help in this.
Reducing the government's economic intervention and continuing with the privatization process while fostering competition, all of which are desirable in the long run, will also help to reduce inflation by making the passthrough mechanism of monetary policy more efficient. Completing the reform of the capital market, which is an integral element of the process of enhancing competition, will make the financial markets more efficient, thereby stimulating growth.
The exchange rate
Within the framework of monetary policy's attempt to attain the inflation target and maintain an exchange-rate regime within a crawling band, the parameters of the exchange-rate band must be consistent with the inflation target. If the former is too steep, the lower limit of expected depreciation will be too high, making it difficult to reduce nominal interest rates in line with the slowing of the inflation environment. Action of this kind could reduce nominal interest-rate spreads between Israel and abroad4, and thereby endanger stability in the foreign-currency market, especially in view of the significant progress that has been made in the liberalization of capital flows. Over and beyond this, the slope of the band also affects inflation expectations, since if it is not in accord with the current inflation environment5 it is more difficult to maintain the slowing of the rate of price increases.
Reduction of indexation arrangements
In view of the efforts to establish inflation in Israel at a lower level, the role of indexation in the government's activities, particularly in the capital market, should be reviewed. Increasing the share of unindexed net borrowing, while extending its horizon, should be considered, inter alia in order to adjust the supply of financial instruments to the changing requirements of the public in a low inflation environment.
4 The foreign interbank interest rate weighted in accordance with the basket of currencies is around 5 percent (as at the beginning of July), so that the minimal sheqel
yield, given a slope of 4 percent on the lower limit of the exchange-rate band, is about 9 percent. The Bank of Israel's key interest rate,
on the other hand, was 11.3 percent in June.
5 The long-term trend of appreciation that characterizes Israel is in accord with a slope
of the band that is lower than the difference in inflation between Israel and abroad.
Nonetheless, the forces for real depreciation that are in evidence when demand slows off-set this influence.
(3) Monetary policy and inflation in the near future
The ability to predict price developments depends on understanding the factors that influence them and the passthrough mechanisms between price policy and its channels. According to various econometric models, the main factors affecting the rate of inflation are changes in M1, the exchange rate against the dollar or the currency basket, real economic activity-all of which are influenced by monetary policy and other factors-and prices abroad. Expectations also affect prices and the efficiency of the passthrough mechanism of monetary policy. Monetary policy does not affect prices immediately, but with a lag of several months. Consequently, the real interest rate that prevailed at the beginning of 1998 should contribute to maintaining the moderate level of price increases later on in the year, assuming that economic activity will remain relatively slack and import and export prices will continue to decline.
Because the moderation of the rate of price increases was accompanied by a rise in the unemployment rate and was also affected by external factors (such as the decline in prices abroad), the persistence of the low inflation environment depends to a great extent on the policy adopted and its credibility.
The path set for the nominal interest rate will be consistent with the inflation targets set by the government, including the continued gradual reduction of inflation in order to attain the price-stability customary in the industrial countries. This should be done very cautiously in order to maintain stability in the foreign-exchange market, in view of the expected yield gaps deriving from nominal interest-rate spreads and the slope of the lower limit of the exchange-rate band. Setting the parameters of the exchange-rate regime in accordance with the inflation target, adhering to the fiscal path, and determining a clearly-defined path for inflation targets that converge towards price stability will make it possible to continue reducing nominal interest.
As Israel gets nearer to the inflation rate of the advanced economies and remains at that level it will be possible to bring nominal interest rates into line with those accepted in the industrial countries, so that nominal interest, inflation, inflation expectations, and real interest will be in accord with the rates currently prevailing there.