Excerpts from the Inflation Report for the Second Half of 2005

31.1.2006
   
Excerpts from the Inflation Report for the Second Half of 2005
  The Consumer Price Index (CPI) rose in 2005 by 2.4 percent, of which 1.9 percent was in the second half of the year (the period reviewed). The main causes of the rise in the index in the period reviewed were the weakening of the NIS against the US dollar and the persistent increase in oil prices.
  During the third quarter indications of the creation of upward pressures on prices became evident, and these increased in number and strength in the last quarter. Although inflation expectations and forecasts were close to the middle of the target range, they incorporated expectations that a rise in the interest rate was getting closer and closer, and the extent of the expected rise kept increasing. The probability of a rise in global inflation also increased due to the rise in energy and commodity prices. These developments supported a hike in the interest rate, and at the end of the year it stood at 4.5 percent.
 
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In July to December 2005 the Consumer Price Index (CPI) went up by 1.9 percent, significantly faster than in the first half of the year (when it rose by 0.5 percent). Thus in the whole of 2005 the index rose by 2.4 percent, in the upper part of the target inflation range of between one percent and three percent a year.
The weakening of the NIS against the US dollar and the rise of oil prices were the main immediate causes of the rise in the CPI in Israel in the period under review.
The Bank of Israel continued reducing the interest rate in January and February, and then halted the process, holding the rate at the low level of 3.5 percent until September. This took place against the background of assessments that at this interest rate, inflation over a one-year horizon was expected to be at the middle of the price-stability target range.
During the third quarter, indications of the creation of upward pressures on prices became evident, and these increased in number and strength in the last quarter. The NIS depreciated, and there were signs of continued rapid growth, which if it persisted would narrow the output gap and thus serve to raise inflation. Although inflation expectations and forecasts were close to the middle of the target range, they incorporated expectations that a rise in the interest rate was getting closer and closer, and the extent of the expected rise kept increasing. The probability of a rise in global inflation also increased due to the rise in energy and commodity prices. These developments supported a hike in the interest rate, and at the end of the year it stood at 4.5 percent.
The economy's continued recovery from the recession, expressed in strong growth for the third consecutive year, was reflected by prices: companies did not absorb increased production costs and maintained a high level of profitability. There was a certain increase in wages during the year, but as it was a modest one, it had no particular upward effect on inflation.
In 2005 fiscal policy supported economic and price stability through the moderate increase in government expenditure while keeping the deficit level.
The change in the NIS/$ exchange rate during the period reviewed was partly due to global exchange-rate trends and capital flows to emerging markets. The exchange rate was also affected by several domestic factors, some of which acted to weaken the NIS, and others, to strengthen it. The forces serving to weaken the NIS included the narrowing of the interest-rate differential, and the equalization of tax rates on domestic investment and investment abroad, which encouraged the export of capital by Israelis. The main factors acting to strengthen the NIS were the surplus in the balance of payments current account, privatization, and the attractiveness of investment in Israeli high-tech industries, which encouraged continued nonresident direct investments in Israeli companies.
The Inflation Report shows that based on macroeconomic models as well as inflation expectations derived from the capital market, including those of private forecasters, it may be assessed that against the background of continued economic growth, rises in the level of interest rates around the world, and a rise in oil prices, inflationary pressures in Israel will build up. Some further rise in interest may thus be required during the year, in order to maintain price stability within the framework of the inflation target.
The Bank of Israel will continue to monitor the situation and examine, month by month, whether it is necessary to change the interest rate.