​Summary:

The Consumer Price Index (CPI) rose in 2004 at a modest rate of 1.2 percent-slightly above the bottom limit for price stability targets. This came following a year in which price changes were below the lower limit of the target range and actually went down by 1.9 percent. Among the factors that contributed to the return of inflation to its target limit were the economic recovery that gained momentum in 2004, consecutive reductions in interest rates by the Bank of Israel since 2003, and a rise in the price of production inputs imported from overseas. Despite the forces that increased the rate at which prices rose, price changes were moderate this year-apparently due to excess production capacity remaining in the market following the recession from 2001 to 2003, and the appreciation in exchange rates for the second consecutive year.

The economic climate was relatively stable this year, thanks to the macroeconomic policy, and both internal and external conditions. Thus, for example, inflation expectations were generally at the target limit, and foreign currency trading was stable, with low standard deviations. There was a gradual devaluation of about 6 percent in the shekel/dollar exchange rate until May, followed by a revaluation at a rate of around 7 percent for the remainder of the year. Stability in the foreign currency market is also evident in light of the continued decline in short-term interest rate differentials between Israel and abroad, which reached historically low levels: interest differentials between the shekel and the dollar came to only about 1 percent in February 2005, after having dropped to 1.65 percent at the end of 2004, while at the end of 2003 and 2002 they stood at 4.2 percent and 7.85 percent respectively.

Against the background of relatively low inflation expectations and market stability, Bank of Israel interest rates continued to fall in 2004 as well. Until April, the Bank continued to reduce nominal interest at a cumulative rate of 1.1 percentage points, to 4.1 percent-a level that was maintained until November. Towards the end of the year, as conditions were again suitable for further reductions, the Bank lowered interest rates by 0.2 percentage points in December, and again in January and February 2005. The nominal interest rate in Israel was 3.9 percent at the end of 2004, and after two additional reductions in early 2005, interest rates in February stood at 3.5 percent.

Chapter 2: Monetary Policy, Inflation and Prices - PDF file