INFLATION REPORT: January-March 2010

January–March 2010
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Letter of the Governor accompanying the Inflation Report for
January–March 2010
This Inflation Report, covering the first quarter of 2010, is submitted to the government, the Knesset and the public as part of the process of assessing the inflation rate in relation 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 declined by 0.9 percent in the first quarter of 2010, mainly due to seasonal factors, but also reflecting government actions––the reduction in the VAT rate and the cancellation of the water surcharge––the cuts in electricity prices, and falls in housing and energy prices. In the previous twelve months the CPI rose by 3.2 percent, and the index excluding housing and energy by about 2.1 percent.
The recovery around the world which had started in the last quarter of 2009 continued, but not uniformly: in the advanced economies the modest recovery was based mainly on very heavy monetary and fiscal intervention, which cannot continue indefinitely but the duration of which will vary, depending on individual country circumstances. In the emerging market economies, however, growth was driven more by domestic demand from households and companies and increases in commodity prices. Inflation rates around the world are generally low, although in the emerging markets there are initial indications of a rise in inflation. Central banks in most advanced economies are keeping their interest rates at a low level, but some of them have started reducing the extent of their use of unconventional instruments.
In the Israeli economy, the recovery in real economic activity and the decline in unemployment continued in the fourth quarter of 2009. Growth was based on the increase in private consumption, which was partly driven by the low level of interest rates, and on the growth of exports, reflecting the effect of the expansion of world trade. Indicators relating to the first quarter of 2010, particularly the Bank of Israel Companies Survey for that quarter, show that business activity continued to increase.
During the first quarter of 2010 prices of financial assets––shares and corporate bonds––and house prices continued to rise. Around the world share prices also rose but somewhat more slowly then in Israel. The increase in share prices world wide and in Israel is due in part to the economic recovery and the expectation that it will persist, but it is certainly also partly the result of the low interest rates prevailing in most countries. Similarly the rise in house prices in Israel is also in significant part a result of low interest rates.
In the first quarter of 2010 the Bank of Israel continued the process of increasing the interest rate, which it sees as part of a process of gradual normalization of the rate. Thus the interest rate was increased from 0.5 percent in September 2009 to reach 1.25 percent in January 2010 and 1.5 percent in April 2010. The reasons for the increases were: the rate of inflation over the previous twelve months, which was above the upper limit of the target inflation range throughout the period; the relatively high level of one-year–forward inflation expectations, both those of forecasters and those derived from the capital market; the continued entrenchment of growth; and the continued increase in the prices of assets, including shares and houses. There were indications, however, that in the last quarter of 2009 and the first quarter of 2010 the rate of price increases in the domestic market moderated to some extent, and there were signs of a slowdown in economic activity in Europe, against the background of debt financing difficulties in several countries.
The nominal effective exchange rate of the shekel continued to appreciate, as it had in the period from April to December 2009, strengthening by a further 3.9 percent from December 2009 to March 2010. The Bank of Israel continued to intervene in the foreign currency market, with the intention of preventing excess appreciation in the effective exchange rate.
On April 21, the Bank of Israel updated its forecast of economic activity for 2010 and issued its first forecast for 2011. The Bank's assessment is that growth will be 3.7 percent in 2010, and that unemployment will continue to decline to reach an average for the year of about 7 percent. The rate of inflation is expected to moderate during the next twelve 12 month to about 2.2 percent. . For 2011, the forecast is for some further improvement in the real economy, and inflation near the midpoint of the target range. The Bank of Israel interest rate is expected to increase gradually during the remainder of this year. The real appreciation reflected by the effective exchange rate in the last eight months of 2009 and its continuation in the first quarter of 2010, and the level of GDP, which is still expected to be below its potential level––the effect of the global crisis on economic activity in Israel––are expected to contribute to the reduction of inflation.
The Bank of Israel will continue to monitor developments in Israel and abroad and implement a policy supportive of growth and financial stability, while striving to return inflation in the next twelve months to around the midpoint of the target range. At this stage the Bank assesses that it will increase the interest rate gradually, at a rate determined by the inflation environment, the entrenchment of growth in Israel and around the world, the development of shekel exchange rates and of asset prices, and interest rate adjustments by other central banks.
Stanley Fischer
Governor, Bank of Israel
* This report incorporates the report on the rise in the money supply, in accordance with section 35 of the Bank of Israel Law, 5714–1954: in each month from January to March 2010 (inclusive) the money supply exceeded that in the preceding twelve months by more than 15 percent. The change in the money supply is discussed in section 1d.