April–June 2010
Letter of the Governor accompanying the Inflation Report for April–June 2010
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This Inflation Report, covering the second 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[1].
The CPI rose by 1.6 percent in the second quarter of 2010, mainly due to seasonal factors. The CPI excluding the seasonal components––fruit and vegetables and clothing and footwear––rose by 0.7 percent. The housing component, which reflects the price of housing services by means of apartment rentals, increased by 2.3 percent in the second quarter, faster than the other components. The rate of inflation over the previous twelve months moderated in the second quarter to 2.4 percent, after a lengthy period in which it was close to or even above the upper limit of the target inflation range.
In the first quarter, the recovery in real global activity and world trade continued, led by the U.S. and the emerging market economies, while growth in Europe was slower. Against the background of the lower than potential level of activity and relatively high unemployment rates, the global inflation environment remained low.
The fiscal debt crisis in several countries, mainly in South Europe, became more severe in the second quarter, leading to a significant rise in the level of uncertainty in the financial markets around the world, including Israel’s. This was most notable at the beginning of the second quarter, until the EU and the IMF announced the availability of funds to assist countries in financial difficulties in the euro zone, and until these countries started to tighten fiscal policies to deal with the crisis. These halted the decline in the financial markets, but the level of uncertainty remained high.
Economic activity in Israel continued to expand in the second quarter, although some of the indicators relating to that quarter point to a slowdown in the rate of expansion. Available data indicates that although domestic demand continued to grow, the increase in exports, which are affected directly by developments around the world, slowed. The recovery trend was also evident in the labor market, with a decline in the rate of unemployment and an increase in the real wage.
The fiscal crisis in some European countries is likely to have an impact on Israel’s economy due to its potential effect on the demand for Israel’s exports and the effect on Israel’s capital markets due to its close links with financial markets around the world.
The shekel appreciated in both nominal and real terms during most of the second quarter; however, in mid- June the trend reversed, and the shekel depreciated until the end of the quarter and in July. Purchases of foreign currency by the Bank of Israel in April and May served to moderate the appreciation of the shekel in those months. In June the Bank of Israel did not intervene in the foreign currency market.
The Bank of Israel’s monetary policy in the second quarter was set in the framework of the process of returning the interest rate to a normal level appropriate to the economic conditions and the inflation environment. At the same time the heightened uncertainty regarding the global economic situation and its effect on Israel’s economy was reflected in a slowing of the pace of increases in the interest rate in the second quarter. The Bank of Israel interest rate was increased by 25 basis points in April 2010 to 1.5 percent, and was left unchanged until July. For August the interest rate was increased by 25 basis points to 1.75 percent. The downward trend in inflation, measured over the previous twelve months, towards the midpoint of the inflation target range, the increased uncertainty about the rate of Israel’s economic recovery later in the year, and the expectation that the major central banks around the world would leave their interest rates at low levels for a considerable time, all lent support to the decision to leave the interest rate unchanged in the second quarter.
To moderate the continued steep increase in housing prices at the beginning of 2010 and the rapid growth of housing credit, affected among other things by the low rate of interest, and to support financial stability, the Supervisor of Banks issued a directive which went into effect on July 1, instructing banks to investigate their housing credit closely, and requiring an additional provision for housing loans with a high loan-to-value ratio. This step is in accord with the approach that in order to implement the central bank’s policy, macro prudential tools should be employed in addition to the usual monetary instruments, to deal with issues related to financial stability. The use of such tools enables a more focused effect than can be achieved by changes in the interest rate, which have broader implications for the economy as a whole.
The inflation rate in the next twelve months is expected to be in the upper part of the inflation target range, and growth is expected to be slightly below 4 percent, so that the negative output gap will contract a little. Nevertheless, due to uncertainty about the development of the crisis in Europe and its effect on the global economy and on Israel’s economy, economic activity and inflation may deviate significantly from the forecasts. The development of housing prices in the near future is also expected to affect the inflation rate.
The Bank of Israel will continue to monitor developments in Israel and world wide and will act to maintain inflation within the target, while supporting real economic activity and the maintenance of financial stability. The path of the interest rate will continue to be determined in accordance with the inflation environment, the situation in Israel’s economy, global developments, including the path of global interest rates, and developments in the exchange rate of the shekel.
The Knesset passed the new Bank of Israel Law in March 2010, and it became effective in June. The new law provides the legal basis for the independence of the Bank of Israel, by clearly defining the Bank’s objectives, its functions, its decision-making methods, and the tools the Bank can use for achieving its objectives and how they can be operated. The Law sets the maintenance of price stability as the main goal of the central bank, together with the support of other objectives of the Government’s economic policy and the support of the stability of the financial system When the Monetary Committee is appointed in accordance with the Law, monetary policy decisions, including decisions on the interest rate, will be made by the Committee.
[1] When the Monetary Committee is appointed, in accordance with the new Bank of Israel Law, interest rate decisions will be made by the Committee.