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Previous Inflation Reports
The full document, in zipped PDF file - 657KB
Inflation Report 2002, July - December
Jerusalem, January 29, 2003
The Inflation Report for the second half of 2002 is submitted to the government, the Knesset, and the public as part of the process of monitoring the course of inflation and adhering to the inflation targets set by the government, and is intended to increase the transparency of monetary policy. Transparency in the management of macroeconomic policy (fiscal and monetary) is an important component of the certainty needed by foreign and Israeli investors.
The Consumer Price Index (CPI) rose by 0.2 percent in the second half of 2002, constituting a 6.5 percent increase for the year as a whole. The annual increase represents a marked deviation from the inflation target for the year, which was 2–3 percent, and an acceleration relative to the 0.9 percent annual average of the last three years. Since the increase in the second half of the year is below the target, and inflation assessments for 2003 are within the target range of 1–3 percent, it is very important to analyze the notable difference in the rate of price rises in the first and second halves of the year.
The acceleration of the rate of price increases in the first half of the year stemmed largely from the accelerated local-currency depreciation of 15.5 percent against the dollar and 17.8 percent against the euro. The depreciation began immediately after the announcement by the government and the Bank of Israel at the end of 2001 of an economic package to stimulate employment and growth. In accordance with the package, the Bank of Israel lowered its key interest rate by 2 percentage points, from 5.8 to 3.8 percent, and the government undertook to reduce its deficit and cancel costly legislation by individual Knesset Members. The object was to change the policy mix, and replace expansionary fiscal policy and restrictive monetary policy with fiscal discipline and monetary expansion. The policy shift was supposed to lead to a reduction in the real interest rate for all maturities, thereby bolstering investment and growth.
By mid-February the concurrent asset portfolio adjustment and depreciation appeared to have come to an end, but when it became clear in March and April that the government was not meeting its commitment to reduce the deficit, which was in fact expanding rapidly, accelerated depreciation and price rises ensued. This was exacerbated by the deterioration in the security situation, as well as the attempt to restrict the central bank’s independence by proposing legislation which went counter to accepted international norms. Inflation expectations, which had varied within the target range in 2002 Q1, exceeded the upper limit in April and May, and yields on both indexed and unindexed government bonds for all terms rose steeply. All this served to imperil financial stability.
The main reason for the cessation of inflation and the rapid depreciation in the middle of the year was the Bank of Israel’s interest-rate hike in June, and this constituted a cumulative 4.5 percentage points, bringing interest up to 9.1 percent at the beginning of July. Fiscal policy also contributed to restoring stability, by raising taxes, including those on labor, and making budget cuts, especially in transfer payments, while again raising the budget deficit target, from 3 to 3.9 percent of GDP, compared with the original target of 1.5 percent of GDP.
Despite the low inflation rate and the local-currency depreciation in the second half of the year, there is still considerable uncertainty, as expressed in the price of NIS/dollar options, for example. Note that some of the basic causes of economic instability have not yet been removed. Thus, fiscal policy continues to create large budgetary deficits, causing the public debt/GDP ratio to soar, the security situation is still problematic, and real economic activity remains weak. The absence of change in these spheres places a very heavy burden on monetary policy when it comes to maintaining stability.
Note, too, the high variability of the monthly rates of change of the CPI, which did not decline significantly in the second half of the year, despite its slower cumulative rate of increase. This development indicates that the process of returning to price stability has not yet entrenched itself.
The marked difference in developments in the two halves of the year indicates that there are several lessons to be learned regarding the management of macroeconomic policy:
The main task for the economy in 2003, after two years of economic slowdown, and a decline in exports, investment, and living standards, is to stop the process of contraction and restore growth. The new government must implement a policy that focuses on reviving investment, increasing employment, maintaining stability, and reducing poverty. The Bank of Israel will support the government’s efforts in this direction.
This Inflation Report was prepared at the Bank of Israel within the framework of the Senior Monetary Forum. The Forum—headed by the Governor—is the inter-departmental team (whose members include the Deputy Governors and the heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Control Departments) within which monetary policy decisions are taken.
The upward deviation from the limits of the target of expected short-term and long-term inflation derived from the capital market for a large part of the period reviewed, and the relatively high level of yields, and other indicators from the financial markets all made it clear that stability was not yet firmly established, and made it necessary to keep the monetary interest at its end-June level throughout the period reviewed. Relative stability was achieved at a relatively high real rate of interest considering the economic recession, due to the great uncertainty regarding future fiscal policy and in the light of other elements of uncertainty, headed by the security situation and the persistent recession, which reduce the economy’s financial soundness.
The full document, in zipped PDF file - 657KB