Inflation Report 2009, October–December

All Press Releases In Subject:
Monetary Policy and Inflation
Final version: 11.2.2010
The full document, in PDF file -

Inflation Report 2009, October-December
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
February 2010
This Inflation Report*, covering the fourth quarter of 2009, 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 rose by 0.5 percent in the last quarter of 2009, reflecting in particular the increase in world energy prices. Prices increased by a total of 3.9 percent in 2009, with relatively rapid increases in April-August due mainly to government policy decisions--the increase in VAT and the temporary increase in water prices; excluding this effect, the CPI rose by 2.8 percent in 2009. The upward trend in the housing price index evident since the summer of 2008 moderated in 2009:Q4, with a rise of 0.3 percent, compared with 2.3 percent in the third quarter. These developments support the assessment that the upward trend in housing prices is slowing.
Developments in the fourth quarter of 2009 reinforce the assessment that there was a sharp turnaround in Israel's economic and financial environment in the second half of the year. This was clearly reflected in the capital market: since the beginning of the recovery in financial asset prices, in March 2009, share and bond price indices have climbed steeply, and in the last quarter of 2009 returned to their record pre-crisis levels. Indeed it seems that the real recovery is quite strong. GDP in 2009:Q4 is expected to show an increase of more than 4 percent over its level in Q3. This indicates that the growth of real activity--first signs of which could seen in the second quarter of 2009 after sharp drops in activity in the last quarter of 2008 and the first quarter of 2009--is becoming more firmly established. According to initial assessments of the Central Bureau of Statistics, GDP increased by 0.5 percent in 2009, a good performance relative to the assessments at the beginning of 2009 predicting a decline of 1.5 percent. The unemployment rate declined slightly in 2009:Q4, breaking the upward trend recorded since July 2008. Thus, the improvement in economic activity is expressed also in the labor market, supporting the assessment that growth is more firmly based.
These developments led to a marked upward revision of the growth forecasts for 2010, and the current forecast of the Bank of Israel is of 3.5 percent growth, and those of some other forecasters are even higher. The sharp change in the economic environment caused a significant reduction in the budget deficit, and the total deficit in 2009, excluding credit, came to 5.2 percent of GDP, almost one percentage point lower than the ceiling specified in the law, which was set in light of the earlier assessments that negative growth would lead to a marked decline in tax revenues.
Economic activity around the world started expanding in the third quarter of 2009 as a result of macroeconomic intervention measures taken in many countries. Growth, however, was accompanied by a very high degree of uncertainty regarding its strength and likely duration. In the fourth quarter macroeconomic data were published that indicated a substantial improvement in production and growth, and even some improvement in the labor markets and the start of a process of replenishing stocks. Against this background many economies' growth forecasts were revised upwards. Some of the global growth, however, was based on significant fiscal expansion, accompanied by considerable increases in public debt. As a result, there was greater concern over the solvency of some countries, which in turn led to the lowering of their credit ratings and their rating outlooks.
The announcements accompanying the Fed and the ECB interest rate decisions towards the end of the quarter under review spoke of the exit strategy from the unconventional monetary expansion measures introduced during the crisis. In contrast, in the UK the decision was taken to increase further its bond purchase program. In Australia and Norway, which were affected relatively slightly by the crisis, the central banks increased the rate of interest. Despite the economic recovery and continued rising inflation expectations, the major central banks still expect inflation to remain moderate, in light of the large negative output gaps in those economies. In some economies, with Japan at the top of the list, there is even concern regarding deflation. Against this, increases in food and energy prices raise the spectre of increased inflation, mainly in the emerging market economies.
Israel's monetary policy adapted to the rapid changes in economic activity and in the inflation environment. When the crisis became more severe, in 2008:Q4 and 2009:Q1, the Bank of Israel adopted a very expansionary monetary policy, which it continued in the second quarter of 2009. In 2009:Q3 the Bank began gradually to rein in the degree of monetary expansion, and in the fourth quarter, when growth in Israel became more firmly ensconced, the Bank boosted the rate of its cutback in monetary expansion, and increased the interest rate by 25 basis points for December and January. At the end of the quarter under review the interest rate was 1.25 percent, and the Bank does not intervene in the foreign currency market on a regular basis, but only when changes in the exchange rate are out of line with the basic economic conditions.
The assessment in the Bank of Israel is that in the first quarter of 2010 prices in Israel will increase at a rate consistent with the achievement of the inflation target, and that the upside and downside risks of deviation are balanced. For the next few months, inflation viewed over the previous twelve months will remain above the upper limit of the target range. This assessment is based on (1) the expected expansion in economic activity, which boosts demand, and increases in world commodity prices, which pushes up prices of factors of production and which are passed on to consumers, and (2) on the contractionary effect of the increases totaling 75 basis points in the Bank of Israel's interest rate, on the relatively slow pace of the global recovery, and the half-a-percentage point reduction in the rate of VAT on 1 January 2010, which will have some downward effect on the CPI in the first months of the year. The Bank's inflation assessment is consistent with the inflation expectations derived from the capital market and those of professional forecasters--both of which reflect expectations that inflation will be in the upper part of the price stability target range.
The Bank of Israel will continue to implement an expansionary monetary policy that seeks to support economic growth, while bringing inflation in 2010 back to the midpoint of the target price stability range. It will do this by means of a gradual return of the interest rate to a "normal" level; the path of the return will be determined in accordance with the inflation environment, the firmness of growth, both global and in Israel, and the pace at which the major central banks increase their interest rates, and will take into account developments in the exchange rate of the shekel. The current conditions, with the risks balanced but with much uncertainty still prevailing, make forecasting developments difficult; in any event, decisions on the interest rate and on intervention in the foreign currency market will be taken on the basis of the latest ongoing assessments of real and financial developments.

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 October to December 2009 (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.

  Inflation: The CPI rose by a cumulative 0.5 percent in the fourth quarter of 2009 (the period reviewed in this Report). Inflation in that quarter reflected mainly the rise in energy prices, a seasonal rise in clothing and footwear prices, and a rise in housing prices (although these dropped in December). In the last twelve months the CPI rose by 3.9 percent, higher than the target inflation range, but reflecting, in addition to the factors mentioned above, also the temporary price increases--mainly in the third quarter--that resulted from government intervention and that contributed 1.1 percentage points to the rise in the CPI. Excluding the effect of that intervention, the CPI rose by 2.8 percent in the last twelve months. Inflation expectations for a year ahead and beyond remained around the 2.5 percent level.
  The global economic environment: Following a deep global recession, that reached a peak at the end of 2008 and continued in the first half of 2009, growth around the world became positive as a result of unconventional macroeconomic intervention measures-monetary, fiscal and financial. Despite the improvement in the global economic situation, the annual rate of growth remains moderate, and is below the rate of growth that usually characterizes exits from recessions. Although the process of recovery from the crisis has started, it is surrounded by certain prominent uncertainty factors: continued fiscal expansion, slack in the labor market, the fragile situation of many banks, and continued macroeconomic support for activity on the one hand, and policymakers' announcements of their intention to end such support on the other. Central banks are continuing with their expansionary monetary policies, and the exceptionally low level of their interest rates is expected to continue until the middle of 2010. Inflation world wide is low, as are inflation expectations, due to the large negative output gap (actual minus potential output).
  Real activity in Israel: the recovery in real activity strengthened in the third quarter, and unemployment fell slightly. Much of the growth can be ascribed to private consumption and increased exports, against the background of the expansion in world trade. The increase in demand served to hold back the expansion of the output gap, thus dampening its moderating effect on prices. Initial indications regarding the last quarter of 2009 suggest that activity continued to expand, and the Central Bureau of statistics estimates growth in the second half of 2009 at 2.9 percent, and in the whole of 2009, at 0.5 percent. It seems that in the fourth quarter the process of recovery from the recession gained strength, and that the exit was taking place faster than had been expected.
  The financial markets: Prices of financial assets in Israel continued to increase in 2009:Q4, in line with their performance around the world and particularly in the emerging market economies, against the background of expectations that real activity would continue to expand and the low level of the Bank of Israel interest rate. Nonbank credit also continued increasing in the last quarter, while bank credit, in particular to the business sector, contracted.
  The exchange rate: In the fourth quarter the trend of appreciation shown by the index of the effective nominal exchange rate shekel halted, and there was actually some depreciation for a short time. This occurred despite the surplus in the current account of the balance of payments and the differential between interest rates in Israel and abroad. The Bank intervened in the foreign currency market only in instances of exceptional strengthening of the shekel exchange rate that did not reflect substantial changes in economic conditions, or when the foreign currency market did not function properly, or when there was evidence of a market failure. In October the Bank of Israel's purchases of foreign currency totaled $1,274 million, in November it did not intervene in the market, and in December it bought $132 million.
  Monetary policy: Monetary policy in the quarter under review expressed the continuation of the move from a very expansionary policy to a slightly less expansionary one, with the Bank of Israel interest rate undergoing adjustments along a gradually rising path towards the level required in the new economic environment. The increase in the interest rate from 0.5 percent in August 2009 to 1.25 percent in January 2010 was made possible as a result of the easing of the risks that the recession would persist, and some increase in inflationary pressures. This, in light of the accumulation of several indicators that showed a significant and ongoing recovery--expectations of continued growth in Israel and globally, albeit with uncertainty about its strength and duration, and an increase in actual inflation to the upper part of the inflation target range, even after excluding the effect of the government intervention. Expected inflation also increased, accompanied by expectations of an increase in the rate of interest. The Bank of Israel kept the interest rate unchanged for February 2010.
  Forecast: The Bank of Israel forecast is that growth in Israel in 2010 will be 3.5 percent, the rate of unemployment will decline to 7.1 percent on average, and the negative output gap will start narrowing. The annual rate of inflation is expected to moderate in 2010, returning to the target range in the middle of the year, and reaching 2.5 percent a year hence--this, alongside a gradual process of increases in the interest rate. The moderation of inflation will continue due to the negative output gap created as a result of the effect of the global crisis on economic activity in Israel and the effective appreciation of the NIS in the last few weeks.
* 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.)
The full document, in PDF file -
To Inflation Reports page