Inflation Report July-December 2004-Letter of the Acting Governor, Dr. Meir Sokoler

Letter of the Acting Governor, Dr. Meir Sokoler
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The Inflation Report for the second half of 2004 is submitted to the government, the Knesset, and the public as part of the process of periodic monitoring of the course of inflation and adherence to the inflation targets set by the government, and is intended to increase the transparency of macroeconomic policy. The transparency of policy, fiscal and monetary, is important as a means of increasing the confidence in the economy of Israeli and foreign individuals and companies, and contributes to the proper functioning of the markets and the economy as a whole.
The Consumer Price Index (CPI) rose by 1.2 percent in 2004, within the target range of price stability, i.e., a rise of between 1 percent and 3 percent, set by the government for 2003 onwards. Thus the monetary policy conducted by the Bank of Israel in the last six years succeeded in firmly establishing the achievement of the disinflation process pursued during the last decade and in maintaining price stability, according to the government's targets. In the last six years, since 1999, annual inflation in Israel has averaged 1.4 percent, within the price-stability target range. This was achieved despite the fact that inflation during this period was more volatile than in other countries in which price stability prevails. As price stability was becoming more firmly based, the financial markets, including the foreign currency market, continued to be stable. At the same time, as part of the Bank of Israel's monetary policy, the short-term nominal interest rate was reduced during the last two years, to reach a level of 3.5 percent in February 2005, a historically low level. This took place against the background of stable conditions reflected by, among other things, inflation expectations at a level consistent with the price stability range, and sometimes even with its lower half. This process of reducing the local-currency interest rate, while the rate in the US started rising recently, led to the contraction of the interest-rate differential between the NIS and the dollar to less than 1.5 percentage points in February 2005.
GDP increased by a rapid 4.2 percent in 2004, annual average, and business-sector product by 6 percent, against the backdrop of economic recovery world wide and a certain easing of the security situation. This growth was accompanied by a rise in employment, mainly in the business sector, reflecting a moderate downward trend in unemployment, from a peak of 10.9 percent in the third quarter of 2003 to 10.2 percent in the third quarter of 2004, alongside a rise in the participation rate in the labor force and a rise in labor productivity. These welcome indications were based on macroeconomic policy which focused on strict fiscal discipline and adhered to long-term budget targets, structural reforms, infrastructure investment, and stability with regard to prices and in the financial markets.
The major objectives currently confronting macroeconomic-policy makers is to secure a firm base for long-term growth and to deal with the problem of poverty and social gaps. This policy must develop from a fiscal strategy designed to reduce the weight of the public sector in the economy, transferring sources into business-sector activity, and continuing with the monetary strategy of price stability. In this context it is important to implement the reform of the capital market according to the recommendations of the Bachar Committee, increasing competition in the financial markets, broadening the range of sources of finance, and reducing the extent of conflict of interests in the banking system. At the same time the structural reforms that have started should continue at a faster pace, and those planned should be implemented, in the public sector, the labor market, the ports, the education system and the infrastructures, as well as the privatization process.
Together with these important steps, special attention must be given to reducing poverty and social gaps. These problems can only be tackled effectively on the basis of a policy that encourages a rise in the rate of participation in the labor force, increased retraining among the weaker segments, improvement in the education system, and focused support of the weak and elderly and other groups in the population unable to participate in the labor force.
The time has come to enact a modern Bank of Israel Law that will clearly set the maintenance of price stability as the prime objective of the central bank vis-?-vis other possible objectives. This Law should clearly state the Bank's operational independence and should establish a Monetary Council, headed by the Governor, that will make decisions regarding the policy and management of the Bank of Israel. Such legislation, according to the standards accepted with regard to central banks throughout the world, will ensure the Bank's ability to meet the goals set before it.
The Inflation Report was prepared in the Bank of Israel within the framework of the Senior Monetary Forum, headed by the Governor. The Forum is the inter-departmental team––whose members include the Deputy Governors and the heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Activity Departments––which discusses monetary policy issues.
Meir Sokoler
Acting Governor