Inflation Report 2009, January - March

All Press Releases In Subject:
Monetary Policy and Inflation
Final version: 18.5.2009
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Inflation Report 2009, January–March
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
May 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.
Prices rose at a much slower rate in the second half of 2008 than in the middle of the year, against the background of the dampening of world commodity prices and declining domestic demand. The Consumer Price Index (CPI) declined by 0.1 percent in the first quarter of 2009, also due partly to seasonal factors. Excluding seasonal factors, the CPI rose in that quarter by 0.5 percent. The rate of inflation over the previous twelve months was 3.6 percent at the end of the first quarter of 2009, above the upper limit of the inflation target range, and significantly lower than the rate in the middle of 2008. At the end of 2008, one-year inflation expectations fell considerably, and in the first quarter of 2009 they settled slightly below the 1 percent lower limit of the inflation target.
The effects of the global crisis on Israel's economy, which at first were milder than its effects on other economies, have since become quite evident in the contraction of economic activity in all industries, with a significant negative impact on exports and domestic uses. At the same time, the financial markets stabilized in the first quarter of 2009: following steep declines in prices of financial assets in the last quarter of 2008, they leveled in 2009:Q1, and the yield gaps between corporate and government bonds steadied and even contracted during the quarter, with some renewal of corporate issues. This may indicate expectations of some easing of the economic situation, but its reflection in the labor market, which generally reacts with a lag to changes in real activity, is likely to take longer.
With the increased severity of the slowdown in economic activity world wide, governments continued to pursue expansionary fiscal policies intended to support the stability of their financial sectors and to promote real activity. Central banks continue to pursue expansionary monetary policies by means of interest rate cuts and other measures.
The Bank of Israel pursued its expansionary monetary policy with the intention of dampening the impact of the global crisis on real activity while preserving financial stability and maintaining price stability. Since the beginning of 2009 the Bank of Israel has cut the interest rate by 2 percentage points, from 2.5 percent in December 2008 to 0.5 percent in May 2009. In addition to cuts in the interest rate, in February the Bank started to buy government bonds in the secondary market, with the aim of supporting the reduction in yields, which provide a benchmark for the determination of medium- and long-term interest on credit in the economy. The Bank also continued its purchases of foreign currency which started about a year ago.
To fix the interest rate at the level declared by the Bank of Israel each month requires the sterilization of the banks' excess liquidity. Otherwise, the shortest term interest rate would fall below the declared rate. The purpose of the foreign currency and government bonds purchases is to help implement an expansionary monetary policy when the possibility of reducing the short-term interest rate has been exploited virtually to the full. All this, to encourage economic activity and to prevent the economy from slipping into an environment of continuous price reductions.
According to Bank of Israel assessments, private forecasters' predictions, and expectations derived from the capital market, the rate of inflation in the year ahead is expected to be close to the lower limit of the inflation target range. The revision of the assessments compared with those in the previous Inflation Report is due to the change of the underlying conditions: on the one hand, the steeper decline in world trade, which acts to slow domestic activity even further, and on the other, the expectation of a moderate increase in world commodity prices. A continued slowdown in global economic activity, with an intensification of the slowdown in domestic activity and stability or reductions in commodity prices abroad, are likely to be reflected in lower, possibly even negative, inflation.
The Bank of Israel will continue to monitor developments in Israel and abroad, and will act to keep inflation within the target range, while encouraging real activity and maintaining financial stability.
Alongside the Bank's monetary policy, which will be implemented using all available tools, the new government should adopt the appropriate fiscal policy to support real economic activity and to reduce the impact of the recession. To enable activity to expand, it is important to ensure the proper functioning of the banking system and the capital market, thus making it easier to finance the activity of the business sector. This, while maintaining the stability of the financial system--a prerequisite for the renewal of sustainable economic growth.

Stanley Fischer

Governor, Bank of Israel

  Inflation: The Consumer Price Index (CPI) fell in the first quarter of 2009 by 0.1 percent; seasonally adjusted it increased by 0.5 percent. In the last twelve months it rose by 3.6 percent, but it did not change uniformly and its development indicates a lower inflation environment than that prevailing before the worsening of the global crisis in September 2008. The background to the sharp fall in the inflation environment was the decline in demand and the drop in world commodity, energy and fuel prices compared with their levels in mid-2008. Inflation expectations also fell and settled below the lower limit of the inflation target range.
  Real activity: In the last quarter of 2008 real economic activity contracted, the output gap widened, and the rate of unemployment increased. Preliminary indicators suggest that aggregate demand continued to decline in the first quarter of 2009. The slowdown in economic activity was mainly the result of the decline in exports against the background of the fall in world trade. The drop in demand, the increase in uncertainty and the impact on the public's wealth support the assessment that the moderate level of activity will continue also in the next quarters.
  The financial markets: The financial markets stabilized in the first quarter of 2008 compared with the previous quarter, but the risk level remains high. Share prices in the Tel Aviv Stock Exchange (TASE) steadied to some extent, the risk premium on corporate bonds was reduced, and there was renewed raising of capital from nonbank sources; these did not revert to the levels prevailing prior to the deterioration of the crisis in September 2008. Against the background of the expansionary monetary policy, the real yield curves of government bonds moved downwards, the nominal effective exchange rate showed shekel depreciation, and for the first time since the third quarter of 2007, there was also real effective depreciation.
  Around the world: the effects of the financial crisis are evident in real economic activity in both advanced and emerging market economies, where together with reduced levels of activity, low levels of inflation were recorded. The IMF expects the fiscal aid programs in the advanced economies to lead to increased government deficits in 2009 in those countries, up to about 7 percent of their GDP. The slowdown in economic activity and concern over deflation in the short term resulted in expansionary monetary policies that included interest rate cuts and quantitative easing.
  Monetary policy: Continuing the actions it took in the last quarter of 2008, the Bank of Israel followed an expansionary policy to bring inflation into the target range, to stabilize the financial markets, and to support economic activity. To achieve these objectives the Bank used three tools: the interest rate, purchases of foreign currency, and purchases of government bonds. In the first quarter the Bank reduced the rate of interest till it reached an unprecedentedly low level of 0.5 percent in April, and it stayed at that level in May. In February the Bank started buying government bonds on the secondary market to lower their yield and thus support the reduction of medium- and long-term interest rates. These purchases average about NIS 200 million a day, and the Bank's intention is to buy bonds to a total of between NIS 15 billion and NIS 20 billion. The Bank also continued to buy an average of $100 million a day of foreign currency to increase the level of the forex reserves and to support the exchange rate.
  Forecast: Against the background of the effects of the crisis spreading to world trade and to domestic demand, the forecasts are for the output gap to widen, GDP to contract by 1.5 percent in 2009, and unemployment to rise to 7.7 percent on average (meaning a level of 9 percent at the end of the year). GDP is expected to grow by 1 percent in 2010. Inflation, measured over the previous twelve months, is expected to enter the target range in the second quarter of 2009, and in light of the widening of the output gap, is expected to be around the lower limit of the target range at the end of 2009.
* The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, defined as an inflation rate of between 1 percent and 3 percent a year. (For details see Box 1 on page 11 in the Bank of Israel Inflation Report No. 17, July-December 2005.)
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