On the Proposal to Raise the Inflation Target for 2002 to 3 percent

29 November, 2001

On the Proposal to Raise the Inflation Target for 2002 to 3 percent

(Postscript to the address by David Klein, Governor of the Bank of Israel, to the Annual General Meeting of the Association of Insurance Agents and Brokers in Israel)

Today’s media carried an item suggesting that a proposal was under consideration to raise the inflation target for 2002 from 2-3 percent to 3 percent. I would like to put forward three reasons for rejecting this idea outright:
1. The two pillars of all macroeconomic policy, in all countries, are the budget and interest-rate policy. It is clear that there has been a setback with regard to the budget. A large deviation from the target deficit is expected in 2001, and everyone agrees that unless the budget proposal placed before the Knesset (parliament) is altered even before the next financial year starts, there will be another deviation from the target deficit in 2002. Significant deviations from the downward deficit path in 2001 and 2002 arouse serious skepticism as to the government’s ability to maintain fiscal discipline; this skepticism grows in the light of the failure to deal effectively with the issue of private legislation. These doubts in themselves already make monetary policy more difficult. Large deficits increase the government’s interest payments in the budget, restrict its freedom of action, and raise the level of interest in the market, all of which lower the possibility of reducing short-term interest. A government decision now to raise the inflation target would undermine the very foundation of macroeconomic policy. 2. The argument in favor of changing the inflation target is not clear yet. In the past I have heard it claimed that "raising the target would make a lower rate of interest possible." Let there be no mistake: manipulating the inflation target would place serious obstacles on our current downward interest-rate path, and would eventually lead to higher interest rates. The reason is simple: it is impossible to mislead the public, and I assume there is no intention to try to do so. If the public, i.e., Israelis and nonresidents who are active in Israel’s economy, cease to believe in the government’s commitment to maintain price stability, its conduct will undergo a 180 degree change of direction. Such a change would damage the financial stability we are currently enjoying despite the difficult economic conditions we are experiencing, and would also be felt in the wages system, first in the public sector. Without stability, there is no investment; without investment, there is no growth. Against the background of the external and internal political situation, we must distance ourselves as far as possible from any move that jeopardizes economic stability. 3. Certain assertions are sometimes made about the interest-rate policy, based on the low rate of inflation in the last three years. Such criticism might have some justification if we were living under laboratory conditions. Unlike the situation in several developed economies: - We are more exposed to international trade and to international capital flows, and therefore also to external effects on activity and prices. - The Bank of Israel must improvise policy instruments, which are naturally blunter than open-market instruments, whereas other central banks have complete operational independence. - We do not have developed and competitive financial markets, which are the main transmission mechanism for changes in the interest rate. - Fiscal policy does not follow a stable path. - Despite the reduction in the annual inflation rate, the monthly price index still fluctuates widely. As a result, the index for one or two months, particularly in the last quarter, can change the rate of inflation for the whole year. That is the case this year. Until September, we were on a path with expected inflation for the year of about 3 percent; the October index slashed this by about a third.
The circumstances described above, and concern about the economic situation, led us to respond positively and attend discussions initiated by the Minister of Finance to formulate a “broad national consensus.” In that context we put forward written proposals for the policy changes needed to boost growth and employment, and we are part of the professional team and of the working teams. If the proposed changes can be adopted, the Bank of Israel too is interested and able to contribute to the change in the general direction.