Inflation Report January - June 2002

01.08.02

Inflation Report January-June 2002

The Governor of the Bank of Israel, Dr David Klein, today submitted the Inflation Report for January to June 2002 to the government, the Knesset and the public. The Report is 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.

The Inflation Report for the first half of 2002 highlights the following points:

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Following low rates of inflation of 1.3 percent, 0 percent, and 1.4 percent in 1999, 2000 and 2001 respectively, the CPI rose by 6.3 percent in the first half of 2002 (the period reviewed), exceeding the 3 percent upper limit of the inflation target range for the year.

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The main force behind the increase in prices was the steep rise in the exchange rate, which totaled 14.5 percent from the time of the announcement of the economic measures in December 2001 to the third week in June.

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Inflation expectations, which express the public’s assessments of the economic forces affecting inflation, rose steeply in the period reviewed: one-year and two-year expectations went above 5 percent and 4 percent respectively, higher than the 3 percent upper limit of the target ranges for 2002 and the next few years.

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The rise in inflation and its causes contributed to a rise in uncertainty in the financial markets in general, and in the foreign currency market in particular. The uncertainty was reflected in a considerable increase in the volatility of the exchange rate, a steep rise in the yields on bonds and an adjustment of the public’s assets portfolio towards greater liquidity.

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The change in the policy mix announced in December 2001—expansionary monetary policy (with a 2-percentage-point reduction in the interest rate) and tight fiscal policy (a deficit of 3 percent of GDP and a return to a downward sloping deficit path for the next few years)—caused a change in the public’s portfolio and adjustments of prices and the exchange rate to the new macroeconomic reality from the time of the announcement till February 2002. The exchange rate rose rapidly (by 11.5 percent), inflation expectations climbed from a level below the lower limit of the inflation target for 2002 to around its upper limit (3 percent), and long-term yields dipped slightly. Following the 0.6-percentage-point increase in the interest rate by the Bank of Israel in March, the exchange rate stabilized, and inflation expectations reverted to the target range.

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From the end of February, the public started to realize that neither the government’s deficit target for 2002 nor the targets for the next few years would be achieved, that GDP growth in the coming years would be low, and that public debt would rise. In addition, from April to June several other elements also led to steep and continuing rises in the CPI, inflation expectations, the exchange rate, and yields on bonds. These included the fact that the agreed abolition of private legislation was not taking place; the proposed amendment to the Bank of Israel Law at the beginning of March which would undermine the independence of the Bank of Israel in formulating monetary policy; the deterioration in the security situation in March; and the appointment of the Rabinovitch Committee on Tax Reform at the end of February, which created uncertainty regarding both the relative yields on the public’s assets and the sources required to finance the reform.

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Inflation went up, despite the rise in unemployment and the economic recession in Israel which became more severe as the security situation worsened. Business-sector product declined, and it was only the sharp increase in defense expenditure that prevented a drop in GDP in the period reviewed. The fall in the rate of growth, the slack in the labor market, and the drop in the business-sector real wage all acted to moderate the extent of price rises.

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In the light of the rise in inflation expectations to above the target of price stability and the undermining of financial stability, the Bank of Israel made a series of interest-rate increases, some of them steep, which totaled 5.3 percentage points in the period reviewed, bringing the interest rate to 9.1 percent at the end of the period. At the same time the government put together a package of measures (including restrictions on private legislation) which was passed by the Knesset, intended to halt the fiscal deterioration and to return the budget deficit to a downward sloping path in 2003, with the purpose of bringing stability back to the markets and prices. The package, however, did not place the economy back onto a path of growth and increased employment, which are essential to the improvement of the public’s welfare.

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At the end of the period there were indications of a reversal of the trend of the exchange rate, the result of the determination shown by macroeconomic policy makers to bring stability back to prices and the financial markets. The exchange rate declined by 5.5 percent from the end of June to the middle of July, and 12-month inflation expectations declined by about 2 percentage points, and were back within the inflation target range by mid-July. It is too soon, however, to assess whether the economy has reverted to the price stability of the last few years.