Inflation Report 2005, January - June

18/08/2005 |  Bank of Israel
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Inflation Report 2005, January - June
Letter of the Governor, Professor Stanley Fischer

Jerusalem, July 2005

The Inflation Report for the first half of 2005 is submitted to the government, the Knesset and the public as part of the process of periodic monitoring of the course of inflation and adherence to the inflation targets set by the government.

The Consumer Price Index (CPI) rose by 0.5 percent in the first half of 2005, and over the last twelve months by 0.3 percent, below the lower limit of the target range (inflation of between 1 percent and 3 percent a year). At the beginning of the year the Bank of Israel reduced its interest rate in two steps to 3.5 percent, with the intention of raising the inflation rate to within the target range. The Bank's ability to reduce its interest rate and to hold it at a low level, contrary to previous assessments in the capital market that the interest rate would be raised during the period, reflected stability in the financial markets and inflation expectations that were around the midpoint of the target range. The maintenance of fiscal discipline made it easier to pursue an expansionary monetary policy that encouraged economic activity.

The question arises: why was the rate of inflation in the last twelve months below the target range despite the cuts in the Bank of Israel interest rate and its low level? The main reason is that the rate at which the exchange rate rose in that period was slower than had been expected. A year ago the assessments in the financial markets, in the Bank of Israel Companies Survey, and those of private forecasters, all pointed to two factors that would cause the NIS to depreciate against the dollar, and hence would raise prices to within the target range: the contraction of the interest-rate differential between the US and Israel, and the equalization of tax rates on foreign and domestic assets at the beginning of 2005. In practice, the exchange rate remained stable for most of the period (to June) despite the cuts in the interest rate, against the background of a significant inflow of long-term capital to Israel.

Economic growth continued in the range of 3.5–4 percent during the first half of the year, and is expected to continue at similar levels in the next half-year and in 2006. Recent declines in unemployment also indicate the consolidation of growth and companies' assessment that it will continue. Growth is being powered by the rise in private consumption and the continued increase in exports, albeit at a slower rate than in 2004 due to a slowdown in the growth of world trade. The continuation of growth in this period was supported by the credibility of fiscal policy––which, together with monetary policy, was reflected in low interest rates––and the extended calm in the security situation. These factors, as well as the relatively favorable environment in the global economy, are expected to continue and to support growth in the coming year too. However, there is as always some uncertainty about the growth forecast. For example, if the security and geopolitical situation should deteriorate to a considerable extent, or if world economic and trade growth slow down significantly, the rate of growth in Israel is likely to be lower than currently predicted.

Inflation is expected to rise in the next twelve months, to a rate within the target range. This will result from continued growth and reduced unemployment, from the low level of the real interest rate, and from the depreciation that has already occurred. Monetary policy will act to achieve the targeted inflation range, and endeavor to prevent both downward and upward deviations from it, while preserving financial stability. At the same time it will support the government's economic objectives, with sustainable growth heading the list.

Stanley Fischer         

Governor       


Summary

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The Consumer Price Index (CPI) went up by a cumulative 0.5 percent in the first half of 2005, and by 0.3 percent in the last twelve months––a rate below the lower limit of the inflation target range of 1–3 percent. This is a continuation of the low-inflation environment that prevailed in the last two years.

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The Bank of Israel continued to lower the interest rate at the beginning of the period reviewed. This took place against the background of a moderate level of price increases, inflation expectations that were within the inflation target range, a reduction in bond yields, and stable domestic currency markets. Thus the interest rate was cut by 0.2 of a percentage point in each of the months December 2004, and January and February 2005, to reach the low level of 3.5 percent.

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In the second quarter the capital and money markets remained stable, while the short-term-interest differentials continued to contract. It seemed that inflation in the next twelve months was expected to be close to the midpoint of the price stability target range. The Bank of Israel therefore kept the interest rate for the months March to June unchanged.

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The NIS/dollar exchange rate is known to have a considerable effect on price changes in Israel, both via its effect on housing prices (most of which are quoted in dollars), and via its effect on imported goods. For most of the first half-year the NIS was traded with no clear trend and with low volatility, and constituted a major reason for the small rise in the CPI. In June the NIS depreciated sharply against the dollar, and the effect of this on prices has not yet been realized in full.

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Global factors, headed by the strengthening of the dollar world wide, served for most of the period reviewed to weaken the NIS (against the dollar), while domestic developments had only a minor effect. In contrast the rapid depreciation that occurred in June was due almost entirely to domestic factors.

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The differential between the short-term interest rates of the US Federal Reserve and the Bank of Israel stood at only 0.25 percentage points at the end of the period reviewed. The contraction of the differential to this unprecedented level without causing shocks in the Forex market could occur in the light of the decline in Israel's country risk and the rise in the US dollar currency risk.

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The continued growth of economic activity in the first half of the year, albeit at a slower rate than in the equivalent period in 2004, and the sharp fall in the unemployment rate in the first quarter of 2005 did not cause upward pressure on prices, as a result of spare production capacity in the economy.

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Two other stabilizing influences affected price rises and monetary policy in the period reviewed: (a) fiscal discipline, which the public afforded credibility despite the delay in approving the budget, and which was reflected by the reduction of future yields on long bonds; and (b) the relative calm in the security situation in Israel at this time.

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The rate of inflation in the last twelve months, which was below the target range, as stated above, was also lower than the level forecast a year earlier. At the end of the first half of 2004 inflation expectations––derived from the capital market, private forecasters, responses of companies participating in the Bank of Israel's Company Survey, and Bank of Israel models––were within the price-stability target range, with a rise expected in the Bank's interest rate. The difference between actual inflation and that which had been predicted derived mainly from the assessments a year earlier that the contraction of the interest–rate differential between Israel and abroad and the equalization of tax rates on domestic and foreign assets would lead to NIS depreciation against the dollar, and hence to price increases. The depreciation did not occur, as mentioned above, despite the response of Israelis to the contraction of the interest-rate differential, mainly due to large unanticipated inflows of capital from nonresidents into the economy.

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Current assessments and expectations––derived from the capital market, private forecasters, companies participating in the Company Survey, and Bank of Israel models––are that prices will rise somewhat faster during the year to a rate close to the midpoint of the target range (2 percent). Some of these assessments are based on the assumption that the Bank of Israel interest rate will be raised a little towards the end of the year. Simulations carried out in the Bank of Israel using economic models show that if the NIS/dollar exchange rate settles at the level it reached at the end of June, and the Bank of Israel interest rate also remains at its present level, the rate of price increases in 2005 will be close to the upper limit of the target inflation range, and in the next twelve months is even likely to exceed it and make it necessary to raise the interest rate thereafter. Under these assumptions, according to the models, a higher rate of inflation than that prevailing hitherto will be caused by continued growth, the reduction of unemployment, the low level of real interest, and the depreciation that has already taken place.



The full document, in PDF file -

Previous Inflation Reports:

   Inflation Report 2004 (July-December)
   Inflation Report 2004 (January-June)
   Inflation Report 2003 (July-December)
   Inflation Report 2003 (January-June)
   Inflation Report 2002 (July-December)
   Inflation Report 2002 (January-June)
   Inflation Report 2001 (July-December)
   Inflation Report 2001 (January-June)
   Inflation Report 2000 (July - December)
   Inflation Report 2000 (January - June)
   Inflation Report 1999 (July - December)
   Inflation Report 1999 (January - June)
   Inflation Report 1998 (January - June)
   Inflation Report 1997