Remarks by the Governor of the Bank of Israel, Professor Amir Yaron, at the “The inflation target in Israel—past, present, and future” conference held today by the Bank of Israel
Before we begin discussing the renewed examination of the inflation target in Israel and abroad, we have to understand the economic background surrounding which the discussion began.
In the years after the crisis of 2008, through the COVID-19 crisis, inflation in many advanced economies, including Israel, was entrenched at below-target levels. Inflation worldwide was characterized by very low, even negative, levels. Alongside that, there was a decline in actual interest rates and in the natural interest rate—the rate that is in line with the state of full employment and price stability.
As a result, the ability of central banks to conduct accommodative monetary policy, in order to support activity and keep the inflation rate within the target range, particularly in periods of significant slowdown in activity, became more challenging. This is because the ability to reduce the interest rate below zero is limited or even not accepted in some countries (ZLB).
In a situation in which the actual interest rate is constrained from below by the minimum possible interest rate, the inflation rate will be lower, on average, and therefore expectations about it as well. Thus, a situation will be created in which there will be a deviation of the inflation rate from the target, and the real interest rate will be higher than wanted, even though it is negative in such a reality. This situation heightens the challenge, as a real interest rate higher than what is wanted leads to an additional moderation in inflation, which is already below the target.
These factors led to the development of a discussion among central banks and the academic world, the goal of which was to examine whether a change was required in the existing inflation target regime. The discussion focused on ways to align the inflation target with changes occurring in the economic environment and the possibility of operating the monetary policy tools in such an environment.
Currently, I would like to raise several important questions that will serve to enhance our understanding of the issue, and that we will discuss, along with many other questions, at the conference ahead of us. Dr. Sigal Ribon will expand upon that.
Defining an inflation target regime is complicated on several levels. On the first level, we would ask if, for example, 2 percent, which is the accepted target today in most countries, is in fact the desired figure or is there room to raise or lower it? Should it be defined as a point or as a range? And should we respond to deviations upward or downward from the point target in a symmetrical manner?
On a different level, we can discuss the period over which we examine the compliance with the target—should it be a period of 1 year, or more?
In addition, it is possible to discuss the price aggregate to which we refer—is price stability measured in terms of the Consumer Price Index? Or net of certain components? Or should it be a different price index, such as, for example, the Producer Price Index or Private Consumption Expenditure?
Many countries define a point target, generally 2 percent, but some add the possibility of some deviation in both directions. Most countries that have defined the target in terms of a range, including Israel, set a band that is 2 percentage points wide. Of them, several countries, including Israel, define the range without noting the midpoint.
The main difference between a point target and a range is in the extent of commitment to the middle value. The existence of a range gives policy makers more flexibility in operating the policy tools while taking into account actual shocks and their source, in the state of the business cycle and the ability to operate the tools, through a deviation of the inflation rate from the middle target.
However, establishing a range without a midpoint value weakens the commitment to a specific value, increases the uncertainty regarding the target toward which policy makers are aiming, and is liable to make to weigh on anchoring long-term expectations at a specific value, such as the midpoint of the target.
Within the framework of an inflation target regime, inflation expectations become a central component in the ability to achieve the target: to the extent that the public’s inflation expectations are anchored in the target, the public’s conduct, particularly setting prices and wages, will be in accordance with the target and will make it possible to achieve it in actuality.
Creating the expectations anchored in the central bank’s target range requires conducting monetary policy that is consistent with achieving the target over time. This issue even sharpens and illustrates the importance of the public relations and communication of the central banks’ monetary policy, an area that has developed considerably in recent years.
As we said, during the course of the day we will hear various approaches to these interesting questions and others.
The uniqueness of small and open economies:
Small open economies (SOEs) have unique characteristics, and thus additional challenges:
The prices of many products are determined exogenously to the economy, and with regard to tradable products, a small open economy is to some extent a price taker. In addition, in an SOE, the exchange rate serves as a significant pass through channel in its impact on prices.
Renewed examination: the process worldwide:
The process of examining the inflation target is a process that is occurring, or has occurred very recently, in many countries. The first four countries that adopted the inflation target regime were New Zealand, Canada, the UK, and Sweden. Today most advanced economies operate within the framework of such a regime, with minor differences in the definition of the actual target.
In 2019, the US Federal Reserve began a broad process of surveying its policy framework in collaboration with external entities from the civilian sector, in order to enhance the level of transparency to the public.
The revised policy framework presented by the Fed in 2020 continues to show maintaining maximum employment and price stability, defined as 2 percent inflation over the long term, as central goals.
The main and perhaps the most important innovation created due to this process is the adjustment of the monetary policy framework. Thus, after a prolonged period of below-target inflation, the Fed will work for some period of time to achieve inflation slightly above the target, so that on average, over time, inflation will be 2 percent. This, by delaying increases in the interest rate, and then a moderate increase, so that it will be lower for a longer period of time. This framework is sometimes known as AIT—Average Inflation Targeting.
However, as this policy framework was described by the Fed, it is not symmetrical—the described adjustment refers only to a case of below target inflation. In addition to this main change, with regard to the labor market, the Fed chose to switch the word “deviations” to the world “shortfalls” in order to emphasize that a stable and strong labor market can be maintained without causing an outbreak of inflation.
After speaking about the process in the US, let’s switch to the EU. Until recently, the inflation target was defined by the ECB as “below but close to 2 percent”. The meaning of such a target was that the ECB attributed more importance to an upward deviation of inflation, above 2 percent, but was prepared to be more tolerant of a deviation to the downside. Like the Fed in the US, the ECB also published in 2021 the results of a process of reexamining its monetary strategy, the first since 2003.
The ECB has now established a symmetrical target around 2 percent, so that its reference to deviations in both directions is identical.
The ECB explained that since the interest rate is near the lower bound, in a case of low inflation, a significantly accommodative and more persistent policy is required, and this could be reflected in a transitory deviation of inflation above the target.
The process in Israel:
Israel was among the first countries to adopt the inflation target as a monetary policy framework. Today it is generally accepted to point to 1997 as the date when the inflation target became the main anchor of the policy. When it first started, the inflation target regime served as a framework that helped in the disinflationary process after the Stabilization Plan in 1985, to an environment of price stability. The process of converging to an environment of price stability was characterized by setting stepped, declining, inflation targets in accordance with the development of inflation in actuality.
Already in September 2019, even before we heard of the world “corona”, I announced in an economic conference that within the framework of the strategic process I initiated when I arrived at the Bank and took on my position, that a team to examine the inflation target in Israel would be set up. Of course, the announcement then was not related to a specific level of inflation, certainly not to the sharp increase that we have seen in recent months in Israel and abroad.
As noted, the learning process began a while ago—and it is continuing. This impressive conference is part of a comprehensive and serious learning process.
The examination process includes various global economic situations, both in terms of the development of inflation and in terms of domestic and global economic activity, which are very important to its success at the end of the examination.
To date, there have been several international conferences organized by the Bank, which included the participation of central bank governors and additional experts in the field; a professional book was written on the issue, led by Research Department Director Michel Strawczynski, and Dr. Sigal Ribon, Head of the Monetary Division in the Research Department; several professional analyses were carried out and research papers were written, and now today our meeting at this event is an additional milestone in the process.
I will conclude with an important statement in my view—we still don’t know how the process will end, it is definitely possible that at the end of the process we will reach the conclusion that the existing regime is correct and there is no need to change it, but we are committed to challenging the thinking from all directions before reaching this conclusion. We shall definitely do that.
Thank you, have a continued productive and beneficial conference.