Letter of the Governor accompanying the Inflation Report for April-June 2009

Letter of the Governor accompanying the Inflation Report for April–June 2009
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.
The CPI rose steeply in the second quarter of 2009, by 2.3 percent, largely due to an 8.0 percent increase in energy prices, and seasonal factors, the most pronounced of which was the 17.1 percent increase in prices of clothing and footwear.
In the first half of 2009 prices increased by 2.1 percent, led by two main categories: energy prices, which increased by 8.1 percent, and housing prices, which increased by 2.8 percent. The rise in the housing component, expressing an increase in rents, which actually started in the middle of 2008, apparently reflects a possible shortage of rental accommodation. The index excluding housing and energy rose by a relatively moderate 1.3 percent (i.e., at an annual rate of 2.6 percent).
Relatively steep price increases are expected in the third quarter in the wake of the increase in indirect taxes and the water surcharge (see below). Despite the above, our assessment at this stage is that the risk of inflation in the next twelve months is low, as there are still forces acting to moderate price increases: the level of demand for domestic production is still far below production capacity; around the world there is substantial excess capacity, a low level of interest rates, and low expected inflation; furthermore, the probability of a sharp depreciation of the shekel, that in the past constituted an inflationary risk factor, currently seems low.
In the last quarter of 2008 and the first half of 2009, economies world wide experienced a serious recession. The decline in activity was accompanied by a significant reduction in world trade, reflecting reduced demand for durables, raw materials, intermediate goods and in particular for final goods. The IMF predicts an 12 percent drop in world trade in 2009. Nonetheless, in the second quarter there were firmer signs that the global recession is approaching its turning point. The expansionary monetary and fiscal policies adopted by most countries started to show results: in the second quarter the global financial crisis eased, share prices rose in stock markets around the world, the credit shortage became less acute, and there were signs of renewed corporate bond and share issues. Global demand and activity, however, are still in a recession.
In the first quarter of 2009, the decline in real activity in Israel's economy that had started in the last quarter of 2008 became more severe, the output gap widened, and the unemployment rate increased. In the second quarter there were indications of a slowdown or even a halt to the decline in activity, and there were several signs suggesting the possibility that in some areas a turnaround was starting (mainly in private consumption and foreign trade). The Bank of Israel Companies Survey for the second quarter shows a moderate decline in total business sector activity, after two quarters of steep drops. Indicators of private consumption[1] show that it was stable in the second quarter, with the possibility of a slight increase, following its decline of 3.9 percent (annual rate) in the previous two quarters. Foreign trade data show a moderation in the decline in goods imports and a modest increase in exports. The fall in direct and indirect tax revenues also moderated in the second quarter.
The rate of unemployment increased to 7.6 percent in the first quarter of 2009, alongside an increase in the participation rate in the labor market, with indications suggesting that the unemployment rate continued to increase in the second quarter.[2]
As the decline in demand affects the labor market with a lag, it can be assumed that the rate of unemployment will continue to rise for the rest of 2009. Wages increased in the first quarter of 2009 compared with the previous quarter, but the real wage was about 3.5 percent lower than in the first quarter of 2008. Health tax revenues in April and May were also lower than in April and May 2008, and also lower than in the first quarter, indicating a further drop in wage payments (meaning either a fall in the number of employees or in the wage per employee, or both).
In the first half of 2009 public expenditure declined (against the background of the delay in passing of the budget), but due to reduced activity, there was a greater fall in tax revenues, and the government deficit grew. In the second half of the year government expenditure is expected (and planned) to increase steeply, following the approval of the budget and in light of the underspending in the first half-year, and the budget deficit is expected to increase further. In order to reduce the deficit, the government decided to increase indirect tax rates. This step together with the increased price of water are expected to contribute an increase of about 1 percent in the price level in the third quarter of the year.
In the second quarter the Bank of Israel interest rate was held at its low level of 0.5 percent, a level set in April 2009. At the same time the Bank of Israel continued with its policy of quantitative easing: it bought foreign currency at a rate of $100 million a day, and bought NIS 200 million of government bonds a day. These steps are intended, among other things, to lower interest rates in the economy, (i.e., to reduce the gaps between longer-term market interest rates and the Bank of Israel rate), and to increase the NIS/$ exchange rate, and thereby to some extent to soften the contractionary impact of the global crisis on domestic demand. These steps also moderated the increase in the second quarter in the yield to maturity on long-term government bonds, a development affected by the expected increase in the government deficit and the increase in long-term yields around the world.
The improvement in the financial sector in Israel continued in the second quarter. This resulted from the improvement in the global financial sectors (which were affected by the expansionary policies of central banks around the world) and from the expansionary monetary measures taken by the Bank of Israel. The effect could be seen in the continued rise in share prices and the significant increase in the issue of corporate bonds by the private sector together with the continued narrowing of the gap between their yields and those on government bonds. These developments indicate the reduced market assessment of risk regarding repayment of corporate debt. This conclusion is supported by company responses to the Companies Survey for the second quarter of 2009, showing that the credit constraint on company activity eased.
Data on credit is available up to May 2009. Total credit to the business sector in May reached close to its December 2008 level. On the one hand its stability reflects an increase of 4.9 percent in nonbank credit, after a decline of 2.8 percent in 2008. The development of nonbank credit reflects the increase in corporate bond issues on the Tel Aviv Stock Exchange which occurred at the same time as the reduction of the yield to maturity, as company risk fell. On the other hand, bank credit to the public dropped by 2.4 percent in the first five months of 2009, having increased by 8.0 percent in 2008. The fall in bank credit occurred concurrently with the decline in its cost, and may mean that there is some slack in demand for bank credit.
Inflation expectations for a year ahead increased in the second quarter to around the midpoint of the target range, both those based on the capital market and those of forecasters (following publication of the June CPI, expectations increased further, and came close to the upper limit of the target range). Apparently the increase in indirect tax rates and in water prices, which are expected to affect prices in the third quarter, and the increase in commodity and oil prices in the second quarter, contributed to the increase in inflation expectations. The next few months may see relatively high price increases, with a rise in the rate of inflation (measured over the previous twelve months), but this is expected to moderate later in the year. This, against the background of the continued recession in domestic and global demand, and the slack that is expected to persist for some time, at least in the labor market.
The Bank of Israel continues to monitor developments in Israel and abroad and will act to keep inflation within the target range, while encouraging real activity and supporting financial stability.
[1] Imports of nondurable and durable goods, indices of consumer confidence, chain store sales, trade and services revenue, purchases via credit cards, Israelis' hotel bed nights, and VAT on imports.
[2] According to the Central Bureau of Statistics trend data, the unemployment rate continued to increase in May, and reached 8.4 percent.