Inflation Report for January - June 2000

July 31, 2000

Inflation Report for January-June 2000

The Governor of the Bank of Israel, Dr. David Klein, today submitted to the government, the Knesset, and public the Inflation Report for the first half of 2000, prepared within the framework of the Senior Monetary Forum which he heads. The Forum, whose members include the heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Control Departments of the Bank of Israel, decides on interest-rate policy.

The report for the first half of 2000 highlights the following points:

Assessments of the rate of inflation for the next 12 months and 24 months-based on forecasts prepared by the Bank of Israel and other financial elements, and on inflation expectations derived from the capital market-indicate inflation of between 3 and 4 percent per year. Expectations for a 3-5 year horizon are in the same region. This rate of inflation, which is consistent with the target set by the government, is closer than it has been in the past to that defined as price stability-the rate prevailing in the industrialized countries.

Dangers still loom in the areas of inflation and finance, arising inter alia from the upward trend of world interest rates, and from rapid and unexpected changes that occur from time to time in international financial markets which could lead to sudden shifts in the public’s assets and liabilities portfolio.

The challenge currently facing interest-rate policy is to preserve and consolidate the low rate of inflation, in accordance with the inflation target set by the government for the years 2000 and 2001. This must be achieved at a time of considerable expansion of economic activity evident since the second quarter of 1999, and in the light of the dangers mentioned above. Price stability is major component of economic stability and an important condition for the achievement of sustained long-term growth and job-creation.

To strengthen the economy’s ability to confront the various dangers successfully and to meet the challenge facing it-of creating sustained growth while enhancing economic stability-it is essential to persevere in the strategy of adopting the norms of the advanced economies:

a. An inflation target for the year 2002 and beyond should be determined within the region described as price stability, similar to the definitions accepted in the industrialized countries. Interest-rate policy will focus on achieving this target and preserving it in the long run. b. The rate of the budget deficit should be published also in terms of the definition adopted in the Maastricht agreement, which are binding for the members of the European Union and accepted world wide. According to that definition, a long-term downward path should be adopted for the budget deficit so that the general government deficit target-including the municipalities, etc.-should be no more than 3 percent of GDP by 2002 at the latest. This is a vital step towards a continued reduction of the high government deficit-which currently exceeds total GDP-to levels determined by the Maastricht standard, i.e., a maximum of 60 percent of GDP. In this context it is essential to stick rigidly to the budget framework, and in particular to government expenditure. A breach of the government’s budget and deficit would harm the rating of Israel’s economy in the international capital markets, increase the cost of raising capital, and could even cut short the process of renewing economic growth and creating jobs at its inception.

c. Economic decision making processes must be adjusted to the reality of long-term low and stable inflation. Thus, the government must bring about a constant reduction in the share of its debt which is CPI-indexed, avoid building a reserve for price rises into the budget, set tax rules on a nominal basis-at least where new legislation is concerned-determine contracts and wage agreements in General Government without indexation clauses, and introduce accounting procedures on a nominal basis, including the publication of financial reports. These steps would create a reality which is the norm in advanced economies.

d. The reform of foreign-exchange market should be completed, so that the NIS becomes completely convertible.

e. Reform in the field of pension, after which pension funds would invest in the capital market and not in earmarked bonds-nonnegotiable government bonds bearing interest unrelated to returns on the capital market.

f. Provident funds and mutual funds should be split off from the banks, and a financial intermediation system more competitive than the present one should be formed, which will benefit savers as well as the capital market.

g. The minimum wage policy should be amended, including the method of updating the minimum wage.

h. Other reforms should be pursued aimed at increasing competition and efficiency in the economy, thereby raising labor productivity.

The Bank of Israel notes that the Inflation Report constitutes part of the periodic follow-up of developments in the area of inflation and of the extent to which the government’s inflation targets are being met, thus increasing the transparency and accountability of monetary policy. Transparency and accountability in the management of economic policy are very important to the Israeli public and to those active in the domestic and international financial markets, particularly in view of Israel’s successful integration into the global economy.