Remarks by the Governor of the Bank of Israel at the press briefing on monetary policy held today at the Bank of Israel
As you know, the Monetary Committee decided today to continue its accommodative monetary policy and to keep the interest rate at 0.1 percent, noting that it intends to maintain the accommodative policy as long as necessary in order to entrench the inflation environment within the target range. The Research Department published its updated macroeconomic staff forecast, and I will refer to it later on.
Since we met here at the previous press briefing, there have been mixed developments in the inflation environment—actual inflation continued to increase moderately, but there was a decline in expectations. The picture of strong economic activity that we saw at the end of 2016 is not markedly different today, and I will expand on that later on. In the foreign exchange market, the appreciation has strengthened, impacting both the inflation environment and activity, and therefore there was a relatively sharp policy response through foreign exchange purchases. Assessments of the global economy are slightly more optimistic now than they were three months ago, though political developments in various countries continue to be a significant cause of uncertainty.
As such, I will expand on how the Monetary Committee views the current situation, and on the policy and its expected effects.
In the past year, there was a moderate increase in the inflation rate, and after almost two years in which inflation was negative, in the beginning of 2017 the inflation rate turned positive, though it is still below the target range. This is despite the dissipation of the effect of factors with a one-off nature that had acted to reduce inflation, and in effect, for the past several months energy prices have made a positive contribution to annual inflation. In the Bank of Israel Annual Report that was published last week, we showed that changes in consumer behavior, such as increasing purchases via the Internet, are acting to enhance competition and thus continue to pressure toward lower inflation. This is a structural change of price adjustment, which is likely to last for some time, but the experience of economies that went through similar processes in the past has taught us that it will not impact on inflation over the long term. The decline in inflation expectations is apparently a result, to a great extent, of the appreciation that strengthened in recent months, and I will expand on it later on. In contrast, among the forces acting to increase inflation are the economy’s approaching full employment and the rise in real wages. As long as the decline in the price of inputs continues, employers will be able to absorb the wage increase without raising prices. This phenomenon was reflected in the spread that opened between the change in the GDP deflator and the change in the CPI. However, this spread has begun to close and is not expected to continue for a long time, and then the wage increase will translate into an increase in unit labor cost, which is expected to act to increase inflation. The increase in inflation among our main trading partners is also expected to contribute to higher inflation in Israel. And so, despite the very low level of short-term inflation expectations, medium term and long term expectations are within the target range, even if they were impacted to some extent by the processes with a short term nature. Monetary policy, in any case, will continue to act to bring inflation to within the target range.
Fourth quarter National Accounts data were quite strong, though they highlighted the need for informed analysis of data that are published. The Bank of Israel’s assessment is that a notable portion of the high growth in the fourth quarter was a result of higher imports of vehicles in December, at a pace that cannot be assumed to continue throughout this year. Even net of this effect, the economy’s growth rate is satisfactory, and indicators available to us at this time point to the pace having apparently continued in the first quarter of 2017 (though it is likely that the growth figure that will be published for it will be low due to the fluctuations in vehicle imports.) The labor market continues to be robust—the increase in real wages continues, and the participation and the employment rates are stable at a high level. The continued decline in unemployment and stability in the job vacancy rate at a relatively high level likely indicate that there has been a further decrease in structural unemployment in the economy.
The picture conveyed from the data on the global economy is slightly more optimistic than what we have seen to date. Indicators of economic activity in major economies were positive: there was an improvement in the growth rate of world trade, there were increases in equity markets in Europe and in emerging markets, and the increase in inflation in most economies continued. In the US, the recovery in activity and the entrenchment of inflation near the target led the Federal Reserve to again increase the federal funds rate, but the interest rate path based on forecasts of Fed officials still reflects accommodative policy, a sign that the recovery still needs the support of accommodative monetary policy. Likewise, there is still uncertainty regarding the economic policy of the new administration. In Europe, too, the recovery stands in the shadow of political uncertainty, which declined slightly after the results of the elections in the Netherlands. However, for now, the ECB is continuing the very accommodative monetary policy. The trend of improvement being evident in emerging markets as well likely points to the beginning of a trend of worldwide recovery. Should this occur, and if the risks to continued growth of world trade as a result of political processes do not materialize, it will be good news for Israel’s economy.
The appreciation in the effective exchange rate continues, and in the past quarter it was 3.1 percent. Despite the widening of the yield gap vis-à-vis the US, the shekel appreciated by 4.5 percent against the dollar as well. Part of the appreciation reflects the relatively good state of Israel’s economy, reflected in, for example, a surplus in the current account and in relatively high growth. However, in our assessment, the sharp appreciation in recent months was partly overappreciation, which reflects, among other things, the very accommodative policy adopted by some central banks. In this regard, it should be emphasized that in the US as well, despite the increase in the interest rate, the Fed is purchasing assets each month to replace previously purchased ones that mature. Beyond its deferring the return of the inflation rate to within the target range, the overappreciation negatively impacts industries in the tradable sector in a manner that is likely to be irreversible. For example, when the transitory factors causing the overappreciation are exhausted, those factories that were unable to stay in operation when the shekel was overappreciated will not be able to return to operating, despite there being justification for their operation when the exchange rate reflects equilibrium. Therefore, in addition to the low interest rate, the Bank of Israel intervenes at times in the foreign exchange market. As could have been seen in recent months, the intervention is more forceful when the actual fluctuations in the exchange rate are less in line with those derived from fundamental forces in the market, in the Monetary Committee’s assessment. I reiterate, as I noted here three months ago as well, there is no ceiling to the foreign exchange reserves, and the Monetary Committee will be able to act in the foreign exchange market as much as required by monetary policy needs.
Despite several factors of supply and demand moving in the direction that should have caused a cooling off in the housing market, and the two most recent observations indicating some stability in prices, it is still too early to conclude that the increase in prices has halted. The monthly rate of new mortgages taken out continues to decline against the background of an increase in mortgage interest rates, in 2016 building starts maintained a rapid pace and there was some acceleration in building completions data, and the number of transactions decreased. The government is taking notable steps to continue to increase the supply of homes and it is important that it persists in that.
The macroeconomic staff forecast presented by the Research Department to the Monetary Committee and published today (recall that it is a conditional forecast based on assumptions regarding exogenous variables) reflects the Department’s assessment that the extraordinary impact of vehicle imports on growth in 2016 is not expected to continue in 2017, when growth is expected to be 2.8 percent. However, in the basic growth rate—that is, net of the fluctuations deriving from vehicle imports—only a moderate decline is expected, with a change in the composition of growth: the rate of growth in private consumption is expected to moderate, and in contrast exports are expected to recover given that the improvement in world trade continues. This composition of growth is also expected to prevail in 2018, when growth of 3.3 percent is expected. The paths of inflation and the interest rate indicated in the forecast are lower than those in the previous forecast, mainly due to the effect of the appreciation that occurred in the exchange rate: inflation is expected to enter the target range only in the second half of 2018, and the first increase in the interest rate is only expected in the second quarter of 2018.
In conclusion, monetary policy continues to act to anchor inflation within the target range, to offset overappreciation in the exchange rate, and to support continued growth. Until now, the impact of the relatively sharp appreciation and the changes in consumer behavior and competition on inflation is stronger than the impact of the increase in wages and the higher inflation worldwide, so that despite the continued increase in inflation in the past year, it is still expected to remain below the target for more than a year.
As such, as I noted at the beginning of my remarks, the Monetary Committee intends to maintain the accommodative policy as long as necessary in order to entrench the inflation environment within the target range.