Introduction

The development of prices in the first half of 1999
Box 1: Measuring the Housing Component in the CPI

The background and factors affecting prices
a. The inflation environment
b. Monetary policy and financial assets
Box 2: The Development of the Public’s Local-Currency Assets in View of the Disinflationary Process
c. The foreign-currency market and capital flows
d. Fiscal policy
e. Real economic developments

The policy required to achieve low inflation in Israel
a. The inflation target
b. Fiscal policy
c. Monetary policy

Report in Accordance with Government Decision no. 4167
Appendix 1: Macroeconomic Targets Set by the Government in the Last Three Years
Appendix 2: Press Releases Regarding Monetary Policy Monthly Programs, January-July, 1999

Summary

• In the first half of 1999 the Consumer Price Index (CPI) fell by 0.4 percent. The six-month decline in prices reflects mainly the partial offsetting of the exceptional price increases in 1998:IV. Bearing in mind the decline in prices since the beginning of the year, the rate of price increases for 1999 as a whole, based on widely-accepted forecasts, is expected to be significantly below the 4 percent inflation target. However, current assessments are that the rate of inflation expected to prevail as of the second half of 1999 is 4–5 percent (annual terms).

• The development of prices in the first half of 1999 occurred in the wake of monetary policy, which served to prevent the price rises at the end of 1998 from spilling over into accelerated inflation. This took place against the backdrop of the continued moderation of real economic activity in Israel, and tranquillity in world financial markets. These events show that it is possible in Israel to prevent exceptional price rises from being translated into a faster rate of inflation, especially when credibility is attached to monetary policy aimed at attaining the inflation target.

• Real economic activity remained moderate in the first half of 1999, for the third successive year. The GDP growth rate remained considerably below its long-term potential, and was even slower than in the preceding two years, as expressed in the further rise in the unemployment rate. The absence of export growth, which has been evident since the second half of 1998, was another prominent feature in the first half of 1999.

• The reduction of inflation to its current level creates an opportunity for Israel’s economy to attain rates similar to those in industrial countries. For this purpose, it is necessary to persist with the strategy of macroeconomic policy: fiscal policy that operates in accordance with a declining path in the budget deficit as a proportion of GDP, making it possible to eventually reduce the tax burden, and monetary policy that focuses on achieving and sustaining price stability. This strategy, alongside the deepening of the structural economic reforms, is the preferred way of restoring sustainable growth in a period of globalization.

1. Introduction

The Consumer Price Index (CPI) declined by 0.4 percent in the first half of 1999 (Figure 1). This reflected mainly the partial offsetting of the exceptional price-increases in 1998:IV that resulted from the rapid local-currency depreciation at that time. Prices declined in the first half of 1999 in the wake of the response of monetary policy to the exceptional price increases, expressed in the substantial interest-rate hike aimed at preventing the price rises from spilling over into a higher inflation rate, as well as in response to the local-currency appreciation that was also affected by the interest-rate hike; this came in the context of the slowdown in real economic activity and tranquillity in world financial markets.

The inflation environment at the end of the period reviewed appears to have been similar to that in the first half of 1998 - about 4 or 5 percent. This assessment of the inflation environment is based inter alia on inflation expectations as derived from the capital market¹ and predictions by forecasters, and is in line with the moderation of the average rate of price increases since 1997:III. Bearing in mind the fall in prices evident since the beginning of 1999, and barring exceptional events, the cumulative increase in prices in 1999 is expected to be below the inflation target (4 percent). The general assessment currently prevailing regarding expected inflation in the second half of 1999 is slightly above 4 percent.

The shekel appreciated against the currency basket and the dollar in the first half of 1999, while the foreign-currency market remained calm. This appreciation partly offset the depreciation evident in the second half of 1998, when there was capital outflow by Israeli residents. Capital inflow by residents resumed, albeit with very different characteristics. In contrast with the past, during the period reviewed foreign-currency credit was taken by a few large companies, and there was a clear switch to long-term credit. At the same time, there was more hedging against exchange-rate shifts in the first half of 1999, apparently expressing greater public awareness of exchange-rate risk. Nonresidents maintained the high level of their investments in Israel, and the expansion of activity by nonresidents in the Tel Aviv Stock Exchange (TASE) at the beginning of the year was one of the factors behind the rise in share prices despite the recession and given the global recovery from the financial crisis. This development and Israel’s credit rating indicates the positive assessment by nonresidents of Israel’s economic fundamentals.

Real economic activity² remained slack in the first half of 1999, for the third consecutive year. Israel’s economic growth rate continued to be substantially below its long-term potential, and was even slower than in the previous two years - expressed in the persistent rise in the unemployment rate. A marked development in the first half of 1999 is the continued low level of exports, a trend that has prevailed since the second half of 1998 and is expressed - together with the rise in imports - in the larger import surplus. In addition, the slowdown in domestic economic activity persisted in the first half of 1999. The expansion of domestic uses beyond GDP growth reflects largely a rise in inventory, whereas the growth rate of other uses remained moderate, and fixed investment continued to fall. Among the causes of the slowdown in the growth rate are the impact of the business cycle, also expressed in the continued process of reducing capital stock in the principal industries and housing, and the slowing of exports, influenced by the slump in world trade. The real depreciation and improvement in the terms of trade do not yet appear to have affected exports. At the same time, the moderation of economic activity was affected by the macroeconomic policy aimed at attaining specific targets: monetary policy focused on attaining the inflation targets, and was expressed in a higher real interest rate than in the last few years, while fiscal policy aimed at a declining deficit to GDP ratio. This macroeconomic policy helps to bolster economic stability.

Nonetheless, in the first half of 1999 the domestic deficit deviated from the path that would enable the deficit target set for 1999 to be attained. This occurred primarily on the income side, and is explained by the shortfall in the expected enhancement of tax collection, on the basis of which expenditure was increased. Other reasons for the shortfall were the reduction in firms’ profits, smaller than forecast rise in prices, and unexpected slowdown in economic activity. The moderation of this deviation for 1999 as a whole depends to a great extent on reducing expenditure in the second half of the year below the customary seasonal path of the budget. In the wake of the slower rate of price increases and decline in inflation expectations, and in the context of the uncertainty in the markets, the Bank of Israel reduced its key interest rate during the period by a cumulative 1.5 percentage points, to about 12 percent (an effective rate of 13 percent). This occurred after a cumulative 4 percentage-point rise in November 1998 in response to developments on the foreign-currency market and simultaneous significant increase in inflation expectations (for 12 months). Inflation expectations, which soared towards the end of 1998, declined at the beginning of 1999 and stabilized later on, so that by mid-June they stood at about 5.5 percent; by mid-July they had declined to about 4.5 percent - a rate similar to that evident in the first half of 1998. The real interest rate, based on the nominal interest rate and inflation expectations derived from the capital market, averaged 7 percent during the period reviewed, similar to its average level in the first half of 1998.

Cautious monetary policy and adherence to a declining path of the budget deficit relative to GDP are important for maintaining the achievement of having reduced inflation, convergence towards attaining and sustaining price stability, and restoring a sustainable growth path while ensuring economic stability and reducing vulnerability. A declining budget deficit path will help to lower the economic involvement of the public sector, ease the tax burden, reduce the public debt/GDP ratio, and stimulate business-sector activity. The composition of the budget, especially giving priority to investment in the physical infrastructure and human capital, is vital for creating the conditions for renewed economic growth while utilizing the potential for long-term growth.

1) These expectations incorporate a risk premium.
2) The data are until 1999:1.

2. The development of prices in the first half of 1999

In the first half of 1999 the CPI declined by 0.7 percent (in annual terms). This followed its 13 percent rise (in annual terms) in the second half of 1998³, most of it between September and November, alongside sharp local-currency depreciation (Figure 2). The development of prices during the period reviewed largely reflects the partial offsetting of the exceptional price rises at the end of the preceding year, the response to the cumulative 4 percentage-point interest-rate hike as well as to the nominal appreciation that accompanied it. This response of prices was supported by the continued slowdown in economic activity and decline in prices abroad. The development of prices in the first half of 1999 is consistent with the convergence of the inflation rate to an environment similar to the one prevailing in the first half of 1998, and indicates that, as a result of the policy adopted, the relatively rapid price increases of the second half of 1998 were not translated into accelerated inflation. In 1999:I the CPI declined by 1.5 percent, and in 1999:II it rose by 1.1 percent. Over a longer period, September 1997 to June 1999, the annualized average inflation rate was between 4 and 5 percent. Despite the rapid price increase evident at the end of 1998, an examination of the cumulative rise from September 1998 to June 1999, also incorporating the price falls at the beginning of 1999, shows that the rate of price increases was similar in this period, too.

The development of prices shows that their response to the sharp local-currency depreciation was rapid but partial, and was corrected to some extent by the reaction to the rise in the interest rate and to appreciation. The partial response is consistent with the hypothesis that the relation between changes in the exchange rate and in prices has been weakened due to the greater volatility of the former and in view of the monetary policy. The weakening of this passthrough was indicated by signs that the nominal depreciation was expressed by real depreciation: the more rapid rise in recent months of prices of tradables (in the CPI) than of nontradables (Figure 3). From September 1998 (until May 1999) prices of tradables (excluding clothing and footwear) rose by an annual rate of 8.9 percent, while those of nontradables (excluding fruit and vegetables and housing) rose by 6.4 percent. The ratio of export prices (in NIS terms, according to National Accounts figures) to the GDP deflator, constituting an index of real depreciation, was 3 percent higher in 1999:I than in 1998:I. The ratio of import prices to the GDP deflator rose by a similar rate.

An examination of real depreciation by comparing the change in the CPI with that in the equivalent abroad⁴ plus the change in the exchange rate, shows that since January 1998 there has been cumulative real depreciation of some 9 percent. According to this measure, cumulative depreciation since the beginning of 1997 has been at a similar rate.

The relative price of housing fell significantly in the last six months; housing prices⁵ declined by 6 percent (in annual terms), whereas the CPI excluding housing rose by 0.7 percent. Wholesale prices, which reflect mainly the prices of manufactured goods, rose by 0.3 percent during this period. The rate of increase of the adjusted indices, from which housing, items characterized by seasonal fluctuations (fruit and vegetables, clothing and footwear) have been stripped out - constituting another indication of the underlying inflation environment - was less volatile than that of the CPI as a whole in the first half of 1999, especially in 1999:I (Figure 4), and similar to that in the first half of 1998. Since the beginning of the year these indices have risen at (annual) rates of up to 2.6 percent, endorsing the view that the inflation environment is consistent with the attainment of the 1999 inflation target - 4 percent.

a. The inflation environment
The inflation environment denotes assessments of the inflation path in the past and the immediate future, provided there are no special shocks and with a given monetary policy, and reflects primarily the forces that have been generated in the past and that affect the rate at which prices rise.

An indication of this environment can be obtained by focusing on inflation in the last twelve months - assuming that this is a long enough period to indicate the underlying trend of inflation - together with inflation expectations for the next twelve months as derived from the capital market and inflation predictions of forecasters, giving another dimension to expected inflation (Figure 5).

The decline in prices and in expected inflation in the first half of 1999 constitutes mainly a partial offsetting of the exceptional price increases of September–November 1998 rather than a significant change in the inflation environment: according to the indicators mentioned, and considering the rate of inflation since September 1997, the environment is assessed at about 4-5 percent a year - a similar rate to that prevailing until August 1998.

The sharp price increases of 1998 came in the wake of the steep local-currency depreciation due to the shocks to world markets triggered by the near-collapse of the LTCM hedge fund at the end of September and the Russian financial crisis of August 1998, as well as against the backdrop of the cumulative reduction of the Bank of Israel’s key interest rate until that month. The price increases peaked in October 1998, and the Bank of Israel acted in November to prevent their being translated into a permanent rise in the inflation rate by raising interest by a cumulative 4 percentage points in November 1998. This, together with the relative tranquillity in world financial markets, succeeded in keeping the inflation environment at a level similar to the one that had prevailed before these events, and helped to calm the foreign-currency market.

The development of inflation expectations (derived from the capital market) was not uniform during the period reviewed: at first they declined gradually from about 8.5 percent in November 1998 to 5.5 percent in February 1999 (Figure 6), alongside local-currency appreciation, which also served to reduce prices, and since the beginning of the year their cumulative rate has been about 5 percent. In March and April inflation expectations stabilized, even rising slightly in May, despite the fact that each month the rate of price increases was lower than earlier forecasts and the exchange rate remained relatively stable. Only in the second half of June, after the CPI for May was published, did inflation expectations begin to decline, reaching 4-5 percent in July (Figure 6).

Inflation expectations derived from the capital market incorporate a risk premium. In the context of the recession and the even steeper actual decline in prices than had been predicted, the relatively high level of expectations derived from the capital market in this period is partly explained by increased uncertainty about the development of inflation, especially in the short term, and expresses two main factors. The first is uncertainty regarding the development of the exchange rate. In the wake of the events towards the end of 1998 some apprehensiveness as to exchange-rate developments - which could lead to price increases involving the risk that these would be translated into a higher inflation environment - still appears to linger (Figure 4). This occurred even though the effect of the exchange rate on prices does not appear to be as strong as in the past, and even though it transpired at the end of 1998 that, in view of the response and credibility of monetary policy, the price increase that followed the local-currency depreciation was not translated into a higher rate of inflation. An expression of this apprehensiveness can also be found among forecasters who, while adjusting their forecasts for 1999 downwards each month, during most of the period reviewed left their predictions for periods of longer than a calendar year unchanged. The second factor is fiscal uncertainty. The budget for 1999 included an overestimate of tax receipts, and for some time it has been evident that unless corrective measures are introduced the year will end with a significant deviation from the budget deficit, making it difficult to meet the deficit target for the year 2000. In addition, there is uncertainty regarding the new government’s expected fiscal policy.

The shekel continued to depreciate against the currency basket until March, when the exchange rate was 9.8 percent above the lower limit of the band (Figure 7). In April, particularly at the end of the month, the exchange rate rose relatively steeply - by 2.7 percent - and this together with increased fiscal uncertainty caused inflation expectations as derived from the capital market to rise in May; this was offset in June, after the exchange rate had declined and stabilized. This development indicates that the depreciation is not necessarily permanent, but rather - in contrast with the past - reflects exchange-rate volatility, so that its effect on prices is relatively small.

During the period reviewed the gap between the path of inflation expectations for twelve months ahead as derived from the capital market and the predictions of forecasters widened (Figure 8). While expectations rose steeply in the last few months of 1998, they declined to 5 percent on average in January 1999. Since then they have been rising slowly, to stand at 5.5 percent in May, with a relatively high variance reflecting, as stated, forecasters’ uncertainty as regards inflation and the probability (albeit slight) of steep depreciation. Only after the publication of the CPI for May, which was also lower than predictions for the month, were inflation forecasts for a year reduced to about 5 percent, and in July went down to 4.6 percent

As stated, in the period reviewed the twelve-month ahead forecasts were higher than the inflation target. On the other hand, the predictions for 1999 including the first six months, when prices rose, declined steadily, and forecasters’ assessments in June were that prices would rise by less than 3 percent in 1999 as a whole. The significance of the gap between predicted inflation for the calendar year and the twelve-month forecasts is that price falls in the first half of 1999 are temporary and constitute an offsetting of the price rises of the end of 1998.

b. Monetary policy and financial assets

Monetary policy
The cumulative 4 percentage-point rise in the interest rate in November 1998 reaffirmed the Bank of Israel’s commitment to attaining the government’s inflation target, and aided in restoring the inflation rate to the region of the target (4 percent) for 1999. At the same time, the strategy of non-intervention in the foreign-currency market, enabling the exchange rate to be determined by market forces, was proved to make monetary policy more effective:

The interest-rate hikes of November brought the Bank of Israel’s nominal (effective) interest rate to 14.5 percent, where it remained until February 1999. This policy - aimed at ensuring that the exceptional price increases evident until the end of 1998 were in fact nonrecurring contributed to the decline in inflation expectations and to a rise in the Bank of Israel’s expected real interest rate, which reached 8.6 percent in February.As assessments that the inflation environment was actually returning to the level that had prevailed until August 1998, and against the backdrop of the decline in prices at the beginning of 1999, the interest rate was reduced by half a percentage point a month - in March, April, and May - to reach an effective rate of 12.9 percent in May (Figure 9).

The greater uncertainty regarding the fiscal policy to be adopted after the elections, the reduction of the interest-rate differential, and the increase in exchange-rate risk contributed to a rise in demand for foreign currency alongside local-currency depreciation, as well as to a rise in inflation expectations as derived from the capital market in May. The Bank of Israel’s real interest rate declined in that month to 5.7 percent, and rose in June to 6.5 percent as a result of the decline in expectations, without there being any change in the Bank of Israel’s nominal interest rate.

The main monetary policy instrument of the Bank of Israel is its auctions for banks’ term deposits, by means of which it offsets changes in the monetary base. During the period reviewed these deposits rose from about NIS 40.3 billion in January to about NIS 43.1 billion in June. This increase was due mainly to the interest on these deposits, while the contribution of government budget flows was negligible.

Capital-market indicators of the effectiveness of monetary policy
Assessments of the inflation environment and the policy required to attain the inflation target rely on various capital-market indicators as well as on inflation expectations; these include the monetary aggregates - primarily M1, developments on the assets markets, fiscal policy, and the state of the economy. The exchange rate and capital flows are also taken into account.

1. Capital-market indicators: An important indicator of the effectiveness of monetary policy is the expected real interest rate set by the Bank of Israel, which is a combination of its nominal interest rate and inflation expectations, which respond to it as well as to other factors such as fiscal policy, the unemployment rate, etc. During the period reviewed this interest rate rose and averaged 7.3 percent, compared with an average of 6 percent in the second half of 1998. As stated, this rise expresses the tighter monetary policy which was required in view of the circumstances noted above. In the first four months of the year this interest rate was stable at a relatively high level, and in June - the end of the period reviewed - it stood at 6.5 percent.

These indicators can be viewed from another angle, i.e., the spread between the Bank of Israel’s daily interest rate and that on 12- month Treasury bills on the one hand, and the real yield on indexed bonds on the other. A positive yield gap indicates expectations of a reduction in the nominal interest rate, as is (usually) the case when monetary policy is tight in order to correct a deviation from the inflation target. A rise in the yield on indexed bonds, which means that the real interest rate has risen, also serves to dampen domestic demand and slow the inflation rate. As can be seen in Figure 10, which gives the yield gap (the Bank of Israel’s interest rate less one-year interest) and the actual inflation rate as a quarterly average, there is a negative correlation between them: if monetary policy is tight and short-term interest is higher than that for a year, the inflation rate declines. In 1999:I, when monetary policy became tighter, actual prices fell.

Expectations that the Bank of Israel would change the interest rate were influenced by the actual inflation rate vis-a-vis the inflation target. As Figure 11 shows, since November 1998 the nominal interest rate for a year has been below the Bank of Israel’s key interest rate, expressing expectations that the interest rate would be reduced; nevertheless, expectations (as derived from the capital market) are above the inflation target. The explanation for this may lie in the greater uncertainty regarding the exchange rate and the trend of inflation, so that expectations as measured from the capital market embody a higher risk premium than in the past, similar to the higher risk premium on foreign-currency options, in the context of the exceptional developments regarding the exchange rate and the rate of price increases in 1998:IV.

The slope of the yield curve for indexed bonds expresses expectations of a change in the real interest rate. This slope was slightly negative at the end of 1998, reflecting expectations that the real interest rate would decline. In the first half of 1999 the curve levelled out as it declined, and in May it stood at 4.9 percent throughout its length. Most of the changes in the curve occur in the short term, and its levelling out expresses the reduction of short-term interest. In June the curve rose again, and its slope became negative (Figure 12).

The drop in twelve-month inflation expectations as derived from the capital market in 1999:I was accompanied by a similar fall in expectations for longer periods. Three-year inflation expectations, which had risen to 6 percent in November 1998, declined to 4.9 percent in March 1999, but were still higher than their level in July 1998 - 3.6 percent - before the financial crisis erupted in Russia.

2. The monetary aggregates: Among the various monetary aggregates, particular importance is attached to the narrow money supply (M1) because of its significant effect on the future inflation rate. If it expands faster than demand for it, there is upward pressure on prices, expressed with a lag of two or three quarters. The development of this aggregate is influenced by the Bank of Israel’s key interest rate (Figure 13). In the last twelve months it rose by 12 percent - above the nominal growth rate that is consistent with the (maximum) inflation target of 4 percent and the GDP growth rate forecast for the year 2000. However, in view of the sharp shifts in the rates at which prices and interest rose in the last twelve months, it cannot be definitively concluded that this created inflationary pressure.Another monetary aggregate indicator is the composition of unindexed local-currency deposits (M2). Most of these deposits, which rose steeply in the last few years, are held as assets for up to three months. Following the increased uncertainty regarding the rate of inflation at the end of 1998, the share of these assets rose to 80.3 percent in January, although this has been declining since then, and was 78.9 percent in May. The share of M2 in the public’s portfolio - about 20 percent - did not change substantially in the last twelve months, not even in the wake of the exceptional developments at the end of 1998. This stability indicates that the public trusts the disinflationary process to some extent. The share of long-term deposits is still relatively low, however.

Assets markets:Among the assets markets which have a significant effect on prices are real estate (apartments and other structures) and shares. In the period reviewed the real-estate market was relatively slack, and this was reflected in a slight dip in both housing prices and the number of transactions. Share prices rose by some 40 percent in the first half of 1999, on the other hand, after increasing by only 3 percent in 1998. The continued rapid rise of share prices, accompanied by a surge in real estate, could create inflationary pressures in the future, via the wealth effect. The rise in share prices is notable in view of the recession, and was influenced inter alia by the abatement of the global financial crisis and the continued surge in leading stock exchanges abroad, which served to increase capital inflow to Israel and increase investment by foreign investors in the Tel Aviv Stock Exchange (TASE), thereby exerting pressure for local-currency appreciation (Figure 21). The rise was mainly in the shares of large companies, while those of other companies increased more moderately - by about 27 percent.

(1) Global developments
The global financial crisis that rocked the international financial markets in the second half of 1998 had mainly dissipated by the end of the first half of 1999.

The credit squeeze that came in the wake of the crisis weakened significantly, alongside a decline in the country risk of emerging markets (Figure 14). The stock markets of the US and Europe are booming (Figure 15) and the recovery is also evident in the stock markets of some emerging economies. The various indices of country risk and of the probability of financial crises in the emerging markets show that there was a marked improvement in the first half of 1999, although they are still higher than they were prior to the crisis. The flow of capital from developed to emerging economies also increased to some extent, and IMF forecasts indicate a substantial rise in such flows in the year 2000. As far as real economic developments are concerned, however, the effect of the global financial crisis was more protracted, as expressed in the slow growth of world trade.

(2) The foreign-currency market
The evaporation of the international financial crisis was also evident in Israel, signalling the economy’s robustness notwithstanding its increased openness following the liberalization of foreign-exchange control. This was expressed in the absence of turmoil in the foreign-currency market alongside the local-currency appreciation, reduction of country risk, and considerable capital inflow.

The exchange rate: In the wake of the global crisis the shekel depreciated markedly against the dollar in October 1998 (Figure 7). The Bank of Israel raised its key interest rate and the global financial markets recovered, giving rise to gradual and continuous local-currency appreciation, which by March was about 10 percent. There was a trend shift in April, when there was depreciation of about 3 percent. The depreciation occurred alongside the announcement of a reduction in the Bank of Israel’s key interest rate, reducing the interest-rate differential and following the increase in political uncertainty prior to the elections. This rise was entirely offset in May and June. The exchange rate also fluctuated far less widely in the first half of 1999, and the exchange-rate against the dollar remained within a relatively narrow range for most of the period. The tranquillity on the foreign-currency market was also expressed in the standard deviation implicit in the premium on the Bank of Israel’s NIS/foreign-currency options (Figure 16). The sharp shifts in the exchange rate at the end of 1998 enhanced awareness of exchange-rate risk, so that derivatives transactions increased.

Country risk: The country risk premium, expressed inter alia in the gap between yields on 3-year Israel government bonds traded in the US and those on US government bonds, declined in the first half of 1999 from 1.25 percent in January to about 1 percent in June (Figure 17).

Formal credit ratings also improved, and in May the FITCH-IBCA (the third largest rating agency in the world) upped Israel’s short-term credit rating (while keeping the same rating for long-term credit). In June the government issued bonds on the Euro market, and the issue was rated A-, similar to the rating of Israel’s outstanding debt. The issue was considerably oversubscribed, and was implemented at about 1 percent above the interest on the French government’s bonds⁶.

6) Because of their substantial weight in it, the French government bonds on the Euro market (DAT) constitute the accepted benchmark for issues in this market.

(3) Capital inflow
The first half of 1999 was characterized by a trend shift in capital flows, with capital inflow of about $ 1.4 billion compared with capital outflow of some $ 0.8 billion in the second half of 1998. Most of the change was in the capital flows of residents.

Capital flows of residents: In the first half of 1999 the extent of foreign-currency credit extended to residents (by domestic banks and directly from abroad) rose (Figure 18). The flow of credit in this period was characterized by a very high level of concentration, most of it being long-term credit taken by a small number of companies to finance leveraged buyouts and infrastructure investment. The profile of credit in 1999 is very different from that of the last few years, when most of it was short-term and was intended to finance current uses. It was also more widely dispersed in previous years, and was taken by a large number of companies in a wide range of industries for many transactions. The dispersal of credit began to contract in 1998, and the trend intensified in 1999. The share of foreign-currency credit in total credit remained stable in the first half of 1999, at a level similar to the one prevailing in mid-1998, after several years in which it had increased. An analysis of the distribution of credit among companies shows that as of September 1998 a process began whereby net credit was repaid by residents, and this trend persisted among small companies during 1999 too, in the context of the decline in the interest-rate spread and rise in credit risk (Figure 18). On the other hand, starting in December 1998 a few large companies increased their foreign-currency credit in a small number of large transactions, and as a result this credit expanded in 1999. Credit to these companies is, as stated, mainly long term, and is less influenced by short-term interest-rate spreads. An examination of the industry distribution of credit shows that credit to the construction industry (which in earlier years had increased its exposure to local-currency depreciation) declined. The currency distribution of credit indicates a rise in the share of dollar credit (alongside a decline in the share of credit in Swiss francs, which was preferred in the past because of its low nominal interest rate, irrespective of exchange-rate risk).

In 1999 the process of accumulating foreign-currency deposits (in Israel and abroad) continued, albeit less intensively than in the second half of 1998, when most of the accumulation was by the business sector.

The changes in the credit and deposits portfolio, and the rise in purchases of instruments to hedge against exchange-rate risk, were expressed in the ongoing decline in the exposure of the business sector to depreciation; this process began when the financial crisis erupted in October 1998 and continued until April 1999. Despite the decline in this exposure, however, it still remained relatively large (Figure 19). The exposure of the business sector is measured as the surplus of foreign-currency liabilities over foreign-currency assets, and is largely the result of the increase in foreign-currency credit to the business sector in view of the interest-rate spread that has prevailed in Israel since the end of 1994 and the business sector’s expectations that local-currency depreciation will be lower than this spread. The crisis in October intensified assessments of exchange-rate risk, leading to a process whereby exposure was reduced.

Capital flows of nonresidents: There was no substantial change in comparison with 1998 in investment in Israel by nonresidents (Figure 20). Most of the change was expressed in an increase in offerings abroad by Israeli companies, compared with the almost total cessation in offerings in the second half of 1998. This change should be viewed in the context of the market for offerings by small companies in the US, which underwent a similar process: a sharp drop in offerings in the latter half of 1998 and their revival in the first half of 1999.

The extent of foreign direct investment in the first half of 1999 was similar to that in the second half of 1998, and considerably more than in the first half of 1998. This category is characterized by a high level of concentration and extensive volatility⁷. Sales on the secondary market remained at a level similar to that of the second half of 1998. This market includes securities traded on the TASE as well as those traded abroad. There were sales in stock markets abroad, whereas on the TASE there was an increase in investment by nonresidents. This increase occurred alongside a rise in both share prices and turnover (Figure 21).

d. Fiscal policy Since 1992, the government has had to meet a declining deficit target as part of its long-term goal of reducing the deficit and the public debt. This strategy helped to minimize the risks of economic crises - including in the balance of payments - thereby enabling sustained growth together with declining inflation. The target total deficit for 1999 is 2 percent of GDP, below the target of 2.4 percent for 1998. Although the target deficit since 1997 has been defined in terms of the total deficit (i.e., domestic plus foreign), the development of the domestic deficit itself is also important, as it is the fiscal factor with the major influence on domestic activity and inflation⁸.

The domestic deficit, cash basis, excluding credit, in January-June 1999 totaled NIS 5.4 billion, compared to a deficit of about NIS 2-3 billion derived from the estimate for the year of NIS 10.4 billion. An analysis of the deficit according to the seasonal pattern of previous years indicates that compared with the estimate there is a significant shortfall of some NIS 4 billion on the income side, with the average monthly shortfall similar to that since October 1997. The shortfall in income is partly due to an overestimate of potential tax revenue which could have arisen from enhanced tax collection - which was unrealized. Lower than planned collection of corporation tax due to reduced company profits in 1998, and slower growth than that used as a basis in the formulation of the budget also contributed to the shortfall of income. By the same analysis, the under-spending on the expenditure side was NIS 1– 1.5 billion, all of which can be explained by the allocation of 5 percent of the budget to the price reserve⁹. Excluding the price reserve, expenses have deviated from the seasonal pattern since the beginning of the year. Judging from the development of income hitherto, and assuming there will be a significant tightening of budgetary discipline in the second half of the year relative to the seasonal pattern, a deviation of about NIS 4–5 billion in the domestic deficit is expected for 1999 as a whole. In 1999, in addition to the uncertainty caused by the volatility of the seasonal pattern, there is further doubt regarding the extent of the extra expenses authorized prior to the general election, whose effect has not yet been fully felt, and regarding future changes in the budget and the degree of adherence to it with the formation of a new government. In the absence of a significantly tighter stance regarding the budget and its implementation, the annual domestic deficit may be even higher.

In 1997 and 1998, the deviation in the domestic deficit was offset by a greater surplus than planned in activities vis-a-vis abroad (which derive from the registration of Bank of Israel income from the foreign-currency reserves as budgetary income without a parallel registration of expenses, mainly interest payments on banks’ deposits in the Bank of Israel). It would appear that in 1999, the surplus in activities with abroad will not differ significantly from that planned, so that the deviation from the planned domestic deficit will be reflected in a significant deviation of about one percent of GDP from the target total deficit. More than a half of the domestic deficit (i.e., NIS 3.2 billion) was financed via domestic borrowing from the public, particularly by means of bonds issues. The balance of the deficit, approximately NIS 2 billion, was financed by government injection (Figure 22).

7) Part of the increase in direct investment (some $ 400 million) derives from tran-sactions between nonresidents - the transfer of shares of Israeli companies from portfolio investors to direct investors - and is therefore recorded simultaneously as a decline in portfolio investment in the secondary market.
8) Another advantage of relating to the domestic rather than the total deficit is that the former does not include the recorded "Profits of the Bank of Israel," thus avoiding the bias in the deficit which would resultt from their inclusion.
9) The price basis of the budget derived from this decision was 2.2 percent. Government ministries may not increase expenditure by more than this amount without an appropriate decision from the Ministry of Finance.

e. Real economic developments

Real activity continued at a moderate level in the first half of 1999, in an environment similar to that which has characterized it since the second half of 1996, with some further slowdown in the rate of expansion of activity in most of the period (Figure 23). The persistent slowdown in activity was expressed in a further rise in unemployment in the first half of 1999 (Figure 24). Towards the end of the first half of 1999 some preliminary indications of increased activity have been evident, but it is still too soon to assess its extent or how long it will continue.

According to national accounts figures, GDP grew at an annual rate of only 1.3 percent in 1999:I (Figure 25). In the last quarter of 1998 and the first of 1999, GDP increased by only 0.6 percent from its level in the previous two quarters and business-sector product remained static. One central feature of the period which has been evident since the second half of 1998 is the lack of export growth. This, together with relatively rapid rise in imports, resulted in an increase in the import surplus.Although uses increased faster than GDP, most of the increase reflected greater accumulation of inventory in 1998:IV and 1999:I, accompanied by a rise in imports, while other uses continued their moderate expansion.

The following may be included among the factors responsible for the continued slowdown in domestic demand: the current stage in the business cycle, including the ending of the process of adjustment of capital stock in the principal industries and in residential construction, and the fall in demand for exports, apparently due to the downturn in world trade in 1998. At the same time, the continuation of monetary and fiscal policies pursued in 1997-98 also contributed to the persistent slowdown. Monetary policy is geared to the achievement of the inflation target, and is characterized by a real interest rate which is high by comparison with those prevailing in the last few years; fiscal policy is geared to a downward-sloping total deficit path. Monetary policy and the downward path determined for the government’s total deficit were adopted with a view to the long term, emphasizing the creation of conditions which will enable the preservation of economic stability, a sine qua non for sustainable growth. Nonetheless, the deficit in the first half of 1999 significantly exceeded that planned; in other words, there was fiscal expansion. General uncertainty at least partially connected with recent political events in Israel may have contributed to the slowdown in activity.

The considerable slowdown in exports was also reflected in the balance of payments. The deficit in the current account in 1999:I rose to $ 0.8 billion, from $ 0.5 billion in the equivalent period in 1998¹⁰. The rise was due to the larger deficit on the goods and services account, and reflects a faster rate of growth of imports than of exports.According to nominal foreign-trade data, the extent of goods exports declined by 4 percent from the level in the equivalent period in 1998. Industrial exports fell at a similar rate, while the high-tech industries (machinery and equipment, electronic components, communications equipment, medical

equipment, etc.) showed the greatest decline, of about 6 percent. In 1999:II signs of some recovery in the exports of these industries were evident (Figure 26). The slower expansion of world trade whose effect on exports was felt only partially in 1998¹¹ (Figure 27) may contribute to the explanation of the latest developments, while real depreciation, which should support the expansion of exports, has not yet been reflected. Exports to the US (excluding diamonds) declined by 9 percent in the period under review from their level in the first half of 1998, accounting for about half of the total fall in exports. Exports to Europe and to Asia both went down by 2 percent (Figure 28). Israel’s terms of trade (the ratio of the index of export prices to that of import prices) improved by more than 2 percent in the first quarter of 1999.

Investment in fixed assets continued to fall in the first quarter of 1999, reflecting the ongoing decline in investment in residential construction which joined other indicators signaling a contraction of activity in the construction industry, and a rise in investment in machinery and equipment. Private consumption remained unchanged in 1999:I, as it had in 1998:IV.

The slowdown in economic activity and growth was accompanied by a rise in the rate of unemployment, which reached 8.6 percent in 1999:I, up from an average of 8.5 percent in 1998. The increase in unemployment reflects a small rise in the participation rate, with no change in the number of employed persons compared with 1998:IV. The number of public-sector employees grew by more than 4 percent in 1999:I from its level in 1998:I, while the number of business-sector employees went up by only 1.5 percent.

The significance of this development is that the recorded rise in the rate of unemployment is only a partial reflection of the real slowdown in business-sector activity. Nevertheless, compared with the number of public-sector employees (seasonally adjusted) in 1998:IV, there was a decline of 1.3 percent in 1999:I. The real wage remained stable in January-April 1999, compared with the equivalent period in 1998; this reflected a slight rise in the real wage in the business sector, and a sharp fall of that in public services, which eroded some of the significant increase in the real wage in the first part of 1998. Part of this reduction may be due to the rapid price rises at the end of 1998 in the wake of the sharp depreciation in that period.

At the end of March, after a strike which lasted several days, a framework agreement was signed by the Histadrut (General Federation of Labour) and the Ministry of Finance regarding the wage agreement for 1997–98 for those unions which are members of the Histadrut and which sign the agreement. It is estimated that the agreement and other changes expected in wages (e.g., wage drift) will lead to a rise of about 8 percent in the nominal wage in 1999¹². The agreement should guarantee calm labor relations between the signatories until October 1999; however, it does not apply to the entire public sector (doctors and teachers, for instance, are not covered), nor does it apply to 1999. The credibility afforded to the ability of monetary policy to prevent an acceleration in inflation seems to contribute to stabilizing inflation expectations, and through them to the determination of a nominal wage rise in the wage agreements in line with that agreed.

10) Data of Israelis’ expenditure abroad were amended with effect from the current ba-lance of payments, according to the Survey of Expenses of those Traveling Abroad. This expenditure is currently lower - and therefore data of the deficit are lower - than those published in the past relating to previous periods.
11) See Chapter 6 of the Bank of Israel Annual Report, 1998, for a wide-ranging analysis.
12) Inflation of 3 percent during 1999, in line with the inflation target, would be reflected in average inflation (the average level of prices in 1999 compared with that in 1998) of about 5 percent, meaning a real wage increase of about 4 percent. A lower rate of price increases would be expressed in a greater increase in the real wage.

4. The policy required to achieve low inflation in Israel

a. The inflation target

In order to underpin the achievement of reducing inflation, and to continue progressing towards rates of inflation of industrialized countries, it is recommended that a long-term inflation target be set, for the year 2000 and the next few years. The target would reflect government decisions about the gradual approach to price stability - the norm in industrialized economies. A long-term target has several distinct advantages over the current one-year inflation targets which are set in the second half of each year and relate only to the next year. Setting a long-term target would help all sectors - private, business, and public - to reduce the uncertainty regarding expectations for a longer term than previously. It would thus enable them to plan their economic activities with more distant horizons, thereby enabling longer term contractual agreements - including labor and wage agreements - to be made. A long-term target also makes it easier for monetary policy to cope with external and other shocks, particularly in preventing them being translated into steeper price rises, because greater certainty regarding the future path of the target strengthens the credibility of the policy, and helps in the formulation of expectations, thus enabling a faster return of the prices path to the inflation target.

b. Fiscal policy

Fiscal discipline is vital for preserving economic stability and for long-term growth, and contributes to the establishment of a low inflation environment in the long term. To correct the expected deviation of the budget deficit from its 1999 target, it is recommended that the path of planned budget expenditure be adjusted downwards, in the light of the lower level of income. It must be ascertained that the deviation has been corrected, so that at the end of the year 2000 the deficit will have returned to its original target, as determined in the Budget Deficit Reduction Law. Fiscal policy which strives to stay within the budget framework is also important from the long-term point of view regarding economic stability and minimizing vulnerability to external shocks. It is also important to have a fiscal policy which has as its goal a long-term downward sloping path for the deficit, which will enable the public debt (relative to GDP) to be reduced. In addition to adhering to the expenditure framework, it is of great importance to allocate resources to the areas which will encourage economic growth, in particular to investment in the physical infrastructure and in human capital. Reduced government intervention in the economy, while lowering the tax burden, and continuing with privatization, which will be accompanied by increased competition, are required to improve economic efficiency and encourage business-sector growth.

c. Monetary policy

Monetary policy will continue acting in accordance with the goal of achieving the inflation target determined by the government. Implementation of the current policy is based on the assessment that the inflation target for 1999 will be attained. Current assessments indicate that in the absence of exceptional occurrences, price increases in 1999 will be below the target level set by the government - 4 percent. Those same assessments relating to a horizon beyond 1999, however, (e.g., for twelve months ahead or longer) point to an inflation rate of slightly more than 4 percent. Monetary policy will continue to act in accordance with the government’s inflation targets, with the purpose of ensuring the convergence to price stability, while reducing the risks of deviations from that path. The nominal rate of interest in the near future will be determined in accordance with the Bank of Israel’s assessment of expected developments in the inflation environment (in relation to the inflation target). The assessment will be based on indicators from the money and capital markets, including inflation expectations, the increase in the money supply, and developments in the foreign-currency market, as well as indicators regarding real and fiscal developments which also affect expected price changes. Continued progress towards price stability, as inflation expectations and forecasts settle at levels consistent with it, will enable the gradual adjustment of nominal interest to levels customary in the industrial countries.

Government decision no. 4167 of August 12, 1998 states: “If the Bank of Israel assesses that expected inflation is going to deviate from the target by more than 1 percentage point, the Governor will notify the Government in writing of the factors assumed to be responsible for the expected deviation, the recommended means for returning expected inflation to the target path, and the estimated time required to return to that path.” Accordingly, the Bank of Israel advises as follows:

Inflation in 1999 will apparently, barring unexpected shocks, be below the target of 4 percent set by the government. Currently (i.e., in July 1999), assessments of the various forecasters and that derived from the capital market are that inflation in 1999 will be about 2 percent. As noted in several parts of this report, this should be seen against the background of the significant gap that has developed between the assessment of inflation for the year 1999 and that for a longer term - beyond the current year - usually taken as the basis for analyses of economic processes.

Expected inflation for 1999, which is now more than one percentage point below the target, is the outcome of the low and even negative rate of price increases in the first half of 1999, especially in the first quarter: in January–June the CPI dropped by 0.4 percent, and in January–March by a significant 1.5 percent. These reductions reflect mainly the partial and nonrecurring correction of the exceptional price increases at the end of 1998: in September–November 1998 the CPI rose by an exceptional 5.8 percent. In the twelve months from July 1998 to June 1999 prices rose at a rate of 5.9 percent. This correction followed the rise in the Bank of Israel’s key interest rate in November 1998. Thus, whereas there are indications that inflation in 1999 as a whole will be below 4 percent, the current assessment for the second half of 1999, for 2000, and even beyond, is that inflation will be close to 4 percent. According to this assessment, the relatively low rate of price increases in 1999 does not yet reflect an essential change in the inflation environment for a term longer than the current year to a level lower than the target environment. The assessment indicates risks regarding inflation, and constitutes one of the bases of continued monetary policy, implemented with a view to the future, in line with government targets, and in the light of the relevant developments. The objective is to provide the firm basis required to achieve sustainable growth.

* Taken from the resolutions.