INFLATION REPORT (No. 32)July-September 2010

July–September 2010
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Letter of the Governor accompanying the Inflation Report for July–September 2010
This Inflation Report, covering the third 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.*
Data relating to the second quarter of 2010 and most indicators relating to the third quarter show continued economic growth–– albeit at a slightly slower pace in the third quarter ––with inflation, except in real estate, still at a low level.
Unlike the continued slow growth in many advanced economies despite their very expansionary monetary and fiscal policies, in Israel economic activity and employment grew rapidly in the second half of 2009 and the first half of 2010. In Israel, as in most other countries, an extremely expansionary monetary policy was implemented at the end of 2008 and the beginning of 2009, to help rescue the economy from the effects of the global crisis. But unlike in many of the leading economies, the Israeli economy responded quickly to the stimulus. By the end of the second quarter of 2010, the economy was close to pre-crisis levels of activity and employment. The return to growth and the closing of the output gap, accompanied by inflation around the upper level of the target range, necessitated adjustments in economic policy.
The challenge facing policy makers is to determine the pace of interest rate changes and the continued use of additional policy instruments, and in particular intervention in the foreign currency market and supervisory measures, such that the successful economic environment – supportive of price stability, growth, and financial stability -- is preserved without creating longer-term imbalances.
GDP grew at a rapid rate of 4.5 percent in the second quarter, maintaining the buoyant rate achieved since the middle of 2009. Output growth was led by the increase in exports, which are expected to expand by about 10 percent in 2010, following their decline at a similar rate in 2009; they are expected to grow by another 6 percent in 2011, despite the predicted continued sluggishness in Israel's main trading partners. The impressive recovery of exports is mainly due to companies' success in retaining existing customers even in target markets experiencing difficulties, while developing trading relations in new markets. The relatively rapid growth was accompanied by increased employment in the business sector and reduced unemployment in the economy, unlike the situation in the US and most Western European countries. Export-led growth was also reflected in the continuing surplus in the current account of the balance of payments. With regard to the budget, the current expectation is that the deficit in 2010 will be between 3.7 percent and 4 percent of GDP, well below the 5.5 percent ceiling for 2010 set when the two-year budget for 2009 and 2010 was approved. This sharply better fiscal performance is mainly a result of the more rapid than expected growth of the economy.
Inflation over the previous twelve months declined to 3 percent in May, and since then it has been within the target range of 1–3 percent a year. Twelve-month inflation forecasts from various sources are for the CPI to rise within the upper part of the target range. One important feature of price developments is the gap that has appeared in the last year between the rise in the housing component of the CPI on the one hand–– 6 percent in the twelve months to September 2010, with an expected increase of up to 8 percent in the next four quarters––and on the other, the relatively slow increase in the other components of the CPI of about one percent in the last twelve months, with a similar increase forecast in the next twelve months.
The general picture of Israel's economy in the third quarter and also assessments regarding the future is positive. Nevertheless, alongside this positive situation there are some developments that give cause for concern and confront macroeconomic policy with challenges: first, house prices and share prices have been increasing rapidly for more than a year; in each case partly due to fundamental forces––the former because the rate of building is slower than the increase in the number of households, and share prices surging because of the high economic growth rate––but both apparently encouraged by the low rates of interest. In the case of housing, recent rates of price increase, at around 20 percent per annum, are not sustainable, and demand the attention of policymakers. Second, there is serious doubt about the rate of recovery from the crisis in many key economies, particularly the US, and also about the financial strength of several European countries and some states in the US.
Several leading economies, including the United States, leading countries in Europe, and Japan need to continue with a greater or lesser degree of expansionary economic policy, despite their large budget deficits and the marked increase in their public debt. In contrast, there is a group of countries that carry less weight in the global economy, that are showing good rates of growth of output and employment, inflation at or slightly above their domestic targets in goods and services prices, but rapid inflation in asset prices – particularly housing prices – that could pose threats to financial stability. In that group of countries, which includes Australia, Canada, Hong Kong, Norway, Singapore and Israel, the expansionary policies implemented since the peak of the crisis should be reversed more rapidly than in the first group. Typically this also requires increases in the interest rate.
These differences in policy requirements, in particular interest rate policy, create serious problems for policy makers in a world of free capital flows, which are sensitive to interest rate differentials among countries. In the absence of a framework for international coordination of monetary policies, including exchange rate policy, each country has been pursuing its policies independently, combining interest rate changes with an increasing element of intervention in the foreign currency market, leading to policy tensions in the international economy.
Against the background of the unusual increase in uncertainty in the currency arena, the Bank of Israel will continue closely to monitor the broad range of economic developments, and will use the instruments available to it to achieve its objectives of price stability, the encouragement of employment and growth, and support for the stability of the financial system, while keeping a close watch on developments in the housing market, and specially on house prices.