Letter from the Governor of the Bank of Israel, Professor Stanley Fischer, presented with the Inflation Report for January?June 2005

31.7.2005
Letter from the Governor of the Bank of Israel, Professor Stanley Fischer, presented with the Inflation Report for January–June 2005
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The Inflation Report for the first half of 2005 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.
The Consumer Price Index (CPI) rose by 0.5 percent in the first half of 2005, and over the last twelve months by 0.3 percent, below the lower limit of the target range (inflation of between 1 percent and 3 percent a year). At the beginning of the year the Bank of Israel reduced its interest rate in two steps to 3.5 percent, with the intention of raising the inflation rate to within the target range. The Bank's ability to reduce its interest rate and to hold it at a low level, contrary to previous assessments in the capital market that the interest rate would be raised during the period, reflected stability in the financial markets and inflation expectations that were around the midpoint of the target range. The maintenance of fiscal discipline made it easier to pursue an expansionary monetary policy that encouraged economic activity.
The question arises: why was the rate of inflation in the last twelve months below the target range despite the cuts in the Bank of Israel interest rate and its low level? The main reason is that the rate at which the exchange rate rose in that period was slower than had been expected. A year ago the assessments in the financial markets, in the Bank of Israel Companies Survey, and those of private forecasters, all pointed to two factors that would cause the NIS to depreciate against the dollar, and hence would raise prices to within the target range: the contraction of the interest-rate differential between the US and Israel, and the equalization of tax rates on foreign and domestic assets at the beginning of 2005. In practice, the exchange rate remained stable for most of the period (to June) despite the cuts in the interest rate, against the background of a significant inflow of long-term capital to Israel.
Economic growth continued in the range of 3.5–4 percent during the first half of the year, and is expected to continue at similar levels in the next half-year and in 2006. Recent declines in unemployment also indicate the consolidation of growth and companies' assessment that it will continue. Growth is being powered by the rise in private consumption and the continued increase in exports, albeit at a slower rate than in 2004 due to a slowdown in the growth of world trade. The continuation of growth in this period was supported by the credibility of fiscal policy––which, together with monetary policy, was reflected in low interest rates––and the extended calm in the security situation. These factors, as well as the relatively favorable environment in the global economy, are expected to continue and to support growth in the coming year too. However, there is as always some uncertainty about the growth forecast. For example, if the security and geopolitical situation should deteriorate to a considerable extent, or if world economic and trade growth slow down significantly, the rate of growth in Israel is likely to be lower than currently predicted.
Inflation is expected to rise in the next twelve months, to a rate within the target range. This will result from continued growth and reduced unemployment, from the low level of the real interest rate, and from the depreciation that has already occurred. Monetary policy will act to achieve the targeted inflation range, and endeavor to prevent both downward and upward deviations from it, while preserving financial stability. At the same time it will support the government's economic objectives, with sustainable growth heading the list.