Inflation Report for July - December 2000

24 January, 2001

Inflation Report for July-December 2000 Governor's letter

The Inflation Report for the second half of 2000 is submitted to the government, the Knesset, and the public as part of the process of monitoring the course of inflation and adherence 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, monetary and fiscal, is essential for the public in Israel and for participants in the domestic and international financial markets, particularly in view of Israel’s integration into the global economy.
In August, as part of the process of adopting the European standard for macroeconomic policy management, the government, for the first time, made a decision regarding an explicit longer-term downward path for inflation targets, at the end of which, in 2003, the inflation target will be between 1 percent and 3 percent a year, a rate which was defined as price stability. This decision means that from 2003 the function of monetary policy will be to preserve price stability in accordance with the above definition.
That will bring the disinflation process to an end, and Israel will join the advanced countries in which price stability already prevails, preserved by monetary policy. The rate of inflation in 2000 was zero percent, below the target of 3-4 percent. The main reason for the difference was the significant and unexpected appreciation of the NIS, in contrast to the depreciation which had been predicted at the beginning of the year. The strengthening of the shekel, in its turn, was brought about by an unexpected surge in foreign direct investment. When making the monthly decisions on the key rate of interest, the Bank of Israel was faced, particularly in the first half of the year, with various forecasts of inflation for 2000 and the next few years which were higher than those actually obtained. A strenuous effort to adjust the key interest-rate path in the second half of the year in order to push inflation up rapidly to the target range might have boosted inflation in the coming years above any path of declining targets, and could have led to unnecessary volatility in interest and inflation rates. Such developments would have adverse consequences for the operation of the financial markets and the economy’s resilience to shocks. The fact that stability was maintained, despite several events which, based on experience, could have undermined stability, provides evidence of this resilience.
events included developments in world markets and in Israel’s economy: the tax-reform recommendations of the Ben-Bassat Committee, the security-related developments and unrest, and the unsettled domestic political situation. The economy’s resilience, also reflected by the fact that its international rating was not changed and by the small fluctuation in the country risk premium, is primarily the result of confidence in the continuation of the current macroeconomic policy-a fiscal policy aimed at lowering the deficit and the government debt, and monetary policy focused on achieving and consolidating price stability. In the light of assessments regarding the slowdown in economic activity in the US, which affects Israel’s economy both directly and indirectly, and with the end of the boom in the US stock market, especially in Nasdaq, which greatly influences Israel’s high-tech industries, it is all the more important to maintain and strengthen the resistance of Israel’s economy to shocks. To achieve this, the government must examine the budget for 2001 to ascertain that it is still on the path set for the reduction of the government deficit, and to chart the route for a lowering of the share of government expenditure in GDP.
It is important in this regard to see that the necessary adjustments
are made, to legislation and to the Knesset Rules of Procedure, to ensure that private members’ bills do not change the essence of fiscal policy. Such steps will lead to the lowering of the domestic debt and its burden on the budget, and will enable a reduction of the backlog in infrastructure investment which has accumulated over many years, a social policy focused on reducing poverty, a narrowing of the gap in the rate of participation in the labor force between Israel and other industrialized countries, and easing of tax rates. These steps must be taken in view of the reality of the global economy and the removal of barriers to the free flow of goods and capital. The economy’s ability to compete depends among other things on the overall tax burden. Competitive tax rates are specially important in high-tech industries, whose activities can easily be relocated elsewhere. It is important to speed up the adaptation of decision-making processes to a low-inflation reality: in the general government sector, contracts and wage agreements must eliminate automatic wage increases-a relic of the high-inflation period; unindexed government debt must be extended steadily to 15 years and longer, a step which would encourage the creation of a market for unindexed mortgages; and the tax system and accounting reports should be put onto a nominal basis, as is the norm throughout the world. In addition, a number of reforms which would also strengthen the economy’s resilience and improve its efficiency should be fully implemented.
These include reform of the
pensions system, to enable investments by the pension funds in the capital market rather than in nontradable earmarked bonds, and to lead to contributory pensions replacing unfunded pensions in a competitive market structure; separating provident funds and mutual funds from the banks to create a more balanced financial intermediation structure; changes in the minimum wage policy, including the method in which the minimum wage is updated; and other reforms intended to increase competition and improve the allocation of economic resources. Israel’s economy has made great strides forward in the last few years in the process of becoming a stable, modern economy, integrating well into the global economy, with high-tech industries in the forefront. The economy can be made even more resilient by continuing the tried and tested macroeconomic policy-a policy which emphasizes fiscal discipline and monetary stability-and implementing the reforms which improve the economy’s competitive structure. These measures are necessary to ensure that the growth potential of the economy is realized on a sustainable basis. 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 heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Control Departments) within which monetary policy decisions are taken.

David Klein Governor