Inflation Report July-December 2004-Summary

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  The Consumer Price Index (CPI) went down by 0.2 percent in the second half of 2004, after rising by 1.4 percent in the first half. The cumulative annual rise in prices came to 1.2 percent, close to the lower limit of the price-stability target range, and followed a price drop of 1.9 percent in 2003.
  In the first half of the year the Bank of Israel continued reducing the monetary interest rate until April, and then halted the process, and until November the interest rate stood at 4.1 percent. This took place against the background of price rises in the second quarter of the year, indicators suggesting that expected inflation was within the target range, and concern regarding the effect on the foreign currency market of the narrowing of the interest-rate differential between the NIS and the dollar with the rise in the interest rate in the US. As more data became available in the third quarter indicating a slowdown in the growth rate, increasing appreciation of the NIS against the dollar with the weakening of the dollar worldwide, and falling long-term yields, the Bank of Israel responded by cutting the interest rate for December 2004, and January and February 2005. The Bank of Israel interest rate in February 2005 stood at 3.5 percent.
  The background to the change in prices and to monetary policy was the responsible fiscal policy implemented during the year, reflected by the cut in public expenditure, and by a deficit that was significantly lower than that in 2003, and even lower than the target for the year. The compatibility of the tight fiscal policy with the expansionary monetary policy helped to boost the public's confidence in the overall macroeconomic policy, thereby enabling the interest rate to be reduced further. The global economic growth that led to accelerated domestic growth, and the political and economic calm throughout the year also formed part of the background. All the above led to stability in the financial markets, which was supported by the reforms carried out in the last few years, in particular the removal of the ceiling on the issue of Treasury bills and the greater flexibility of the exchange-rate band.
  The moderate rise in prices over the year as a whole and their reduction in the second half were related to changes in the exchange rate––depreciation of the NIS against the dollar in the first half-year, that served to raise prices, and appreciation against the dollar in the second half, that tended to lower them. The level of activity did not put upward pressure on prices, despite the rapid rate of economic growth; this was due to excess capacity. Acting in the opposite direction, the rise in world fuel prices exerted upward pressure on prices in Israel.
  In the second half of the year the exchange rate of the NIS showed low volatility with a trend of appreciation, and it appreciated by 4.2 percent against the dollar and by 0.7 percent against the currency basket. The relative stability of the foreign currency market was the result of a balance between the forces that affect the exchange rate: those acting to weaken the NIS were opposed by domestic and global factors that tended to strengthen it.
  The effect of the cumulative reductions in the interest rate during the last two years and the low level of short-term real interest currently prevailing are expected to raise the rate of inflation in 2005. Based on assessments of inflation for the coming year derived from the capital market, private forecasters predictions, and the Bank of Israel's Companies Survey, inflation is expected to rise to between 1 percent and 2.5 percent. The assessment in the Bank of Israel is that in order to keep within the target range of price stability during the next twelve months a certain rise in the interest rate will be required, the extent of which will depend among other things on interest-rate developments world wide.