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Preliminary translation: 4.11.2009
The full report, in a PDF file -

Inflation Report July-September, 2009
Letter of the Governor accompanying the Inflation Report
(Report Number 28)
Bank of Israel Jerusalem
4 November 2009

This Inflation Report, covering the third quarter of 2009, is submitted to the government, the Knesset and the public as part of the process of assessing the inflation rate in relation to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.
Developments in the third quarter of 2009 bolstered the assessment that there has been a rapid turnaround in Israel's economic and financial environment. In the last quarter of 2008 and at the beginning of 2009 exports and GDP declined considerably, against the background of the global economic crisis, the CPI fell, and share prices and corporate bond prices slumped. At that time the crisis was expected to become more severe, with forecasts of further deterioration in the economic situation. Inflation was expected to be below the target range in 2009 or even negative. The situation began to change gradually at the end of the first quarter of 2009: the turnaround started with the recovery of the financial markets in March, with increases in share prices as well as a renewal of private bond issues; this was followed by an upturn in economic activity in the second quarter, and the rate of inflation increased and reached above the upper limit of the target inflation range.
The following selected facts demonstrate the speed and the strength of the turnaround:
In the third quarter the CPI rose by 1.3 percent, or at a 5.2 percent annual rate, whereas between April and August it had risen at an annual rate of 9 percent. The steep price increases were mainly due to non-recurring government policy measures-chiefly an increase in the VAT and a temporary surcharge on water prices in light of the drought-and to increases in the housing component which occurred despite the appreciation of the shekel vis-?-vis the dollar. This contrasts with the 2.2 percent reduction in prices in the last quarter of 2008 (annual rate, not seasonally adjusted). In December 2008 inflation expectations for the next twelve months derived from the capital market were of a negative 0.7 percent, below the target range of 1-3 percent annual rate. In the third quarter this reversed, and average expectations returned to close to the upper limit of the target range. More recently, inflation expectations have declined to 2.2 percent, close to the midpoint of the range.
In the last quarter of 2008 and the first quarter of 2009 GDP declined by 2.5 percent compared with its level in the third quarter of 2008, (annual rates, seasonally adjusted). However, in the second quarter of this year growth, at an annual rate of 1 percent, returned to the economy. At the time of the publication of the Bank of Israel Annual Report for 2008 (in April 2009), the Bank's forecast of GDP growth was of a negative 1.5 percent in 2009 and zero growth in 2010; in the most recent update, in September, the figures were revised upwards to zero growth in 2009 and 2.5 percent in 2010, figures which are at the lower end of the range of forecasts published by other professional bodies.
The sharpest change took place in the financial markets: in the period from the end of August 2008 to the end of February 2009 the Tel Aviv 100 index dropped by more than a third, and the Tel-Bond 60 index by more than 12 percent. Since the beginning of the recovery, in March 2009, these indices have started rising again, and they are currently higher than they were prior to the deterioration of the crisis in September 2008.
The change in the economic environment naturally led to changes in various aspects of economic policy. On the fiscal side, in the first quarter of 2009 assessments of the 2009 budget deficit reached close to 6 percent of GDP, based on the view that negative growth would substantially reduce tax revenues and would increase expenditures related to the system of automatic stabilizers, such as payments of unemployment benefits. The authorities also made plans for the possibility (that was not realized) that they would need to support the financial system, as indeed occurred in many other countries. By the end of the third quarter assessments of the budget deficit were and are lower than earlier forecasts, and the financial system is seen as being stable.
Monetary policy was also adjusted in light of the changes in the situation. When the crisis deteriorated in the last quarter of 2008 and the first quarter of 2009, the Bank of Israel pursued highly expansionary policies, which continued in the second quarter of 2009. In the third quarter, the Bank gradually began to reduce monetary expansion. Three monetary tools were used to effect these policies:
1. After reducing its interest rate rapidly in the last quarter of 2008 and the first quarter of 2009, from 4.25 percent in September 2008 to 0.5 percent in April 2009, it increased the rate for September to 0.75 percent. Nevertheless, the interest rate is still low, particularly in light of the improved economic situation, and it is aimed at continuing support for the recovery, which has not run its course.
2. The revised assessments in the third quarter of GDP and export growth led to a change in the Bank's policy of intervention in the forex market. When it launched its policy, in March 2008, its purpose was to increase Israel's foreign exchange reserves, which at that time were low by international standards, and in light of the increased risks due to the crisis. When the reserves reached the stated target level, the Bank continued to buy dollars on the market at a fixed rate of $100 million a day, in order to moderate the appreciation of the shekel and to soften the blow to exporters resulting from the crisis. Thus the reserves increased from $28 billion in February 2008 to $58 billion in August 2009. Over the first few days of August, the Bank phased out its policy of buying a fixed daily amount of dollars and replaced it by a policy of intervening in the market in the event of unusual movements in the exchange rate which are inconsistent with underlying economic conditions.
3. In August 2009 the Bank ended its activity in the government bond market, a policy it had adopted to lower medium and long-term interest rates. The Bank had started buying bonds in February 2009, when it announced its program of daily bond purchases of about NIS 200 million until it had purchased between NIS 15 billion and NIS 20 billion. The Bank reached this target in August, in line with the program, and stopped buying bonds.
The sharp and rapid change in the economic environment confronts monetary policy with a new challenge--to strike a balance between the aim of supporting the still fragile real recovery, and considerations of price stability and financial stability, in light of indications of increases in prices of commodities, services, and assets, and in particular, housing.
Decisions on the interest rate and intervention in the forex market will be taken in light of ongoing assessments of these opposite trends, with the intention of achieving the inflation target while continuing to support the recovery of real activity and financial stability.


Stanley Fischer

Governor, Bank of Israel

Summary
  Inflation: The Consumer Price Index (CPI) rose in the third quarter of 2009 by a cumulative 1.3 percent. The factors providing the background to the price increases in this quarter were the government intervention in the form of temporary increases in indirect taxes, renewed increases in world energy and commodity prices, the continued expansionary monetary policy, and recovery in the financial markets, together with signs of a resurgence of real activity. In the last twelve months the CPI rose by 2.8 percent--within the price stability target range. Inflation expectations were below their level in the previous quarter, and are currently within the inflation target range.
  The global environment: In the quarter under review the risks to the stability of the global financial system eased, and real activity showed some recovery. The early signs of recovery appeared against the background of low rates of inflation, and monetary policy in many countries continued to maintain low interest environments, while employing quantitative expansion tools. Central bank interest rates are expected to remain at their low level for a considerable time, until the recovery in economic activity gathers momentum and excess capacity contracts significantly.
  Real activity: In the second quarter of 2009 real activity increased in Israel, following two quarters of contraction, and the rate of unemployment stabilized. The increase in demand in the third quarter helped to moderate the increase in excess capacity, but did not reduce it. This, together with the absence of pressure from the labor market that was reflected in reduced unit labor costs, meant that real activity did not constitute a source of inflationary pressure on the supply side.
  The exchange rate: In the third quarter, against the background of the worldwide weakening of the US dollar, the shekel showed a trend of appreciation against most currencies. Thus the transmission mechanism from the nominal effective exchange rate served to offset the global forces acting to increase prices in Israel.
  The financial markets: In the third quarter the financial markets continued along the upward path that started in the second quarter. Asset prices continued to increase, and reached their September 2008 level, prior to the deterioration of the crisis. In contrast, the risk premium on corporate bonds stabilized. Against the background of the expansionary monetary policy the real yield curves of government bonds shifted downwards.
  Monetary policy: In the third quarter of 2009 monetary policy was faced with the challenge of dealing with a sharp change in assessments of the economic situation, with the transition from a definite crisis and price falls at the beginning of the year to a recovery of economic activity, with the added complication that the recovery was accompanied by great uncertainty regarding its strength, weakness in the labor market, and a rise in the inflation environment that started at the beginning of the second quarter. The gamut of indicators available to the Bank of Israel during the third quarter supported the continuation of monetary expansion with some reduction in its intensity, in order to sustain the recovery in economic activity, stabilize the financial markets, and return inflation to within the legally defined target range. Monetary policy was expressed by changes in the mix of the tools the Bank had employed in the previous quarter: first, the Bank stopped buying government bonds, in line with the declared program, assessing that the program had indeed helped the market to start functioning properly again. At the beginning of August the Bank changed its method of intervention in the forex market: it moved from a daily purchase of a fixed amount of foreign currency to a variable intervention--with regard to timing and amount--whenever it considers that the exchange rate is not in accord with the fundamental economic conditions. Interest rate policy in the period reviewed was reflected in the interest rate for July and August being held at the low level of 0.5 percent, and its increase by 0.25 percentage points for September, in light of the assessment that the previous level was no longer appropriate taking into account the turnaround in economic activity. Thus the interest rate at the end of the third quarter stood at 0.75 percent, and it remained at that level for November.
  Forecast: The output gap is expected to widen in the coming months, despite the recovery of domestic demand, as growth rates are still low compared with the economy's potential growth. GDP in 2009 is expected to be at the same level as in 2008, and unemployment to increase to 8.1 percent. In 2010 GDP is expected to grow by 2.5 percent., and inflation, measured over the previous twelve months, is expected to be close to the midpoint of the target range.
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