The Inflation Report for January-March 2009. (Report Number 26)

The Inflation Report for January–March 2009. (Report Number 26)
  This Inflation Report, covering the first quarter of 2009, is submitted to the government, the Knesset and the public as part of the process of monitoring the inflation rate and comparing it to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.
  Prices rose at a much slower rate in the second half of 2008 than in the middle of the year, against the background of the dampening of world commodity prices and declining domestic demand. The Consumer Price Index (CPI) declined by 0.1 percent in the first quarter of 2009, also due partly to seasonal factors. Excluding seasonal factors, the CPI rose in that quarter by 0.5 percent. The rate of inflation over the previous twelve months was 3.6 percent at the end of the first quarter of 2009, above the upper limit of the inflation target range, and significantly lower than the rate in the middle of 2008. At the end of 2008, one-year inflation expectations fell considerably, and in the first quarter of 2009 they settled slightly below the 1 percent lower limit of the inflation target.
  The effects of the global crisis on Israel's economy, which at first were milder than its effects on other economies, have since become quite evident in the contraction of economic activity in all industries, with a significant negative impact on exports and domestic uses. At the same time, the financial markets stabilized in the first quarter of 2009: following steep declines in prices of financial assets in the last quarter of 2008, they leveled in 2009:Q1, and the yield gaps between corporate and government bonds steadied and even contracted during the quarter, with some renewal of corporate issues. This may indicate expectations of some easing of the economic situation, but its reflection in the labor market, which generally reacts with a lag to changes in real activity, is likely to take longer.
  With the increased severity of the slowdown in economic activity world wide, governments continued to pursue expansionary fiscal policies intended to support the stability of their financial sectors and to promote real activity. Central banks continue to pursue expansionary monetary policies by means of interest rate cuts and other measures.
  The Bank of Israel pursued its expansionary monetary policy with the intention of dampening the impact of the global crisis on real activity while preserving financial stability and maintaining price stability. Since the beginning of 2009 the Bank of Israel has cut the interest rate by 2 percentage points, from 2.5 percent in December 2008 to 0.5 percent in May 2009. In addition to cuts in the interest rate, in February the Bank started to buy government bonds in the secondary market, with the aim of supporting the reduction in yields, which provide a benchmark for the determination of medium- and long-term interest on credit in the economy. The Bank also continued its purchases of foreign currency which started about a year ago.
  To fix the interest rate at the level declared by the Bank of Israel each month requires the sterilization of the banks' excess liquidity. Otherwise, the shortest term interest rate would fall below the declared rate. The purpose of the foreign currency and government bonds purchases is to help implement an expansionary monetary policy when the possibility of reducing the short-term interest rate has been exploited virtually to the full. All this, to encourage economic activity and to prevent the economy from slipping into an environment of continuous price reductions.
  According to Bank of Israel assessments, private forecasters' predictions, and expectations derived from the capital market, the rate of inflation in the year ahead is expected to be close to the lower limit of the inflation target range. The revision of the assessments compared with those in the previous Inflation Report is due to the change of the underlying conditions: on the one hand, the steeper decline in world trade, which acts to slow domestic activity even further, and on the other, the expectation of a moderate increase in world commodity prices. A continued slowdown in global economic activity, with an intensification of the slowdown in domestic activity and stability or reductions in commodity prices abroad, are likely to be reflected in lower, possibly even negative, inflation.
  The Bank of Israel will continue to monitor developments in Israel and abroad, and will act to keep inflation within the target range, while encouraging real activity and maintaining financial stability.
  Alongside the Bank's monetary policy, which will be implemented using all available tools, the new government should adopt the appropriate fiscal policy to support real economic activity and to reduce the impact of the recession. To enable activity to expand, it is important to ensure the proper functioning of the banking system and the capital market, thus making it easier to finance the activity of the business sector. This, while maintaining the stability of the financial system––a prerequisite for the renewal of sustainable economic growth.