Preliminary version: 2.8.2006
Final version: 8.8.2006
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Inflation Report 2006, January - June
Letter of the Governor, Professor Stanley Fischer

Jerusalem, July 2006

The Inflation Report for the first half of 2006* is submitted to the government, the Knesset and the public as part of the process of periodic monitoring of the course of inflation and adherence to the inflation target set by the government.

The Consumer Price Index (CPI) rose by 1.6 percent in the first half of 2006. Over the past 12 months the index rose by 3.5 percent, above the upper limit of the target range of price stability (between 1 percent and 3 percent a year).

The main reasons for the rise in prices in the first half of the year were the increases in import prices, particularly the sharp rise in prices of energy products, and an increase in local demand, particularly in private consumption. Developments in the exchange rate were not uniform over the period: in the first quarter of the year, the NIS depreciated against the dollar by 2.5 percent, contributing to a rise in inflation in that period; from April, influenced by both local factors and against the background of a weakening dollar in the international markets, the NIS strengthened against the dollar by 5.5 percent, serving as one of the moderating forces affecting inflation in the latter months of the first half. The continuing reduction in the budget deficit also contributed to the moderation in price rises in the period reviewed.

In the first four months of the year the interest rate was raised cumulatively by 0.75 percentage points to 5.25 percent, continuing the rise in the interest rate in the last quarter of 2005. In the latter months of the period reviewed the Bank of Israel stopped raising the interest rate, on the assessment that the inflation rate in the coming year would lie within the target range. At the end of the first half, the Bank of Israel interest rate stood at 5.25 percent.

For most of the period under review, the inflation rate over the previous 12 months was more than 3 percent, above the upper limit of the target range; this was affected by the depreciation of the NIS which began in the last quarter of the previous year and continued until February 2006, the sharp rise in prices of imported goods, particularly energy products, and a contraction in the output gap.

The Bank of Israel follows a flexible inflation targeting approach to monetary policy. In the event that inflation deviates from the target range, this approach allows some flexibility in the speed at which monetary policy attempts to return inflation to within the range. This is done to avoid unduly affecting real activity. In present circumstances, if the inflation rate over the previous 12 months does revert, as expected, to within the target range in July, then the path of interest-rate hikes taken in the period reviewed would have been consistent with this approach to inflation targeting.

At the end of the six-month period under review, a security crisis broke out in the Gaza Strip. This was followed in mid-July by an outbreak of fighting on the Lebanese border. The effect of these events on real activity, the exchange rate and on inflation, will depend in large part on the length of the conflict and on its geopolitical outcome. It is clear though that in the short run these events will have a negative impact on real activity, both from the demand side and through their effect on supply. Despite the rise of the risk premium in the economy, the response to these events in the financial markets, including the foreign exchange market, has so far been moderate. Nevertheless, due to these events, inflation is expected in the short term to rise above its previously expected level. The Bank of Israel, in conducting monetary policy in the coming months, will need to take into account both the possible rise in inflation and the likely slowdown in activity.

At the end of July, the Bank of Israel raised the interest rate by 0.25 percentage points, due to the continuing impact of the main inflationary factors that were in place in the first half of the year, and following the rise in Israel's risk premium--including the inflationary risk--in the markets.

The recent military conflict is expected to impact both revenues from taxes and government expenditure, due to the increased spending on defense and the compensation to those citizens affected by the conflict. However, due to the overperformance of the budget in the first half of this year, the government should be able to meet its deficit target for 2006 if the hostilities end soon. In determining the budget for 2007, it will be important for the government to make every effort to maintain the budgetary framework that it declared before the conflict. Its capacity to do this will depend on the length and the extent of the hostilities in the north and on geopolitical developments.

Stanley Fischer         

Governor       


* This report incorporates the Report on the Expansion of the Money Supply, in accordance with section 35 of the Bank of Israel Law, 1954. This is the case because in each month from January to June 2006 the money supply exceeded that in the preceding twelve months by more than 15 percent. The changes in the money supply are discussed in section IIc(iii) below.



Summary

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In the first half of 2006 (the period reviewed) the Consumer Price Index (CPI) rose by 1.6 percent. Over the last twelve months the index rose by 3.5 percent, above the upper limit of the price-stability target (of 1-3 percent inflation a year).

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Monetary policy in January-April entailed interest rate increases totaling 0.75 of a percentage point, following the hikes in the last quarter of 2005. In May and June the Bank of Israel did not raise the interest rate, based on assessments that, given the appreciation of the NIS, the rate of inflation in the next twelve months would be within the target range. At the end of the first half of 2006 the interest rate was 5.25 percent.

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The exchange rate did not follow a steady path in the period under review: in the first quarter of the year the NIS depreciated against the dollar, mainly due to domestic factors, continuing the trend that started at the end of 2005. In April the trend reversed and the NIS appreciated sharply against the dollar, reverting to its mid-2005 level. These movements of the exchange rate were the dominant factor affecting inflation in January to June 2006. Their effect was reflected by price changes of both tradable and nontradable goods, particularly in the housing category.

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The foreign currency market was affected by several processes that supported appreciation of the NIS; these included a heavy capital inflow by nonresidents, a steadily increasing current account surplus in the balance of payments, and expectations of an improvement in Israel's credit rating. Israelis' continued adjustment of their asset portfolios, reflected by capital outflow by institutional investors and households, acted in the opposite direction.

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The sharp rise of import prices, especially fuel prices, and the increase in domestic demand, mainly private consumption, were among the main reasons for the rise in prices in the period under review.

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Accelerated economic growth in the first half-year was reflected by the contraction of surplus production capacity, and thereby contributed to rise in the GDP deflator. Despite a considerable rise in the average nominal wage in the business sector (about 5.4 percent in the last twelve months), the fact that labor productivity also rose kept unit labor cost stable, so that at present the labor market is not creating apparent inflationary pressures..

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The domestic financial markets were more stable in the period reviewed than most markets abroad. This despite the greater geopolitical uncertainty in the first months of the year, and despite declines in the domestic stock market that occurred against the background of sharp drops in share prices in emerging markets and significant weakening of their currencies towards the end of the first half of the year. This stability of the markets can be attributed in no small measure to the high degree of public confidence in the fiscal and monetary policies.

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According to all the assessments derived from the capital market, the assessments of private economic forecasters, the Bank of Israel's Companies Survey and the Bank's econometric models, inflation in 2006 and in the next twelve months is expected to be within the price stability target range (of 1-3 percent inflation a year), assuming moderate increases in the interest rate in the next year and relative stability in the exchange rate.

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At the end of the first half of the year a security crisis erupted in the Gaza Strip area, and then also on Israel's northern border. The effect of these events on real activity, on the exchange rate, and hence also on inflation, depends to a great extent on how long the current hostilities continue and on their outcome. It may be stated even at this stage that the events will have a negative effect on real activity, both on the demand side and through the impact on supply. However, despite the increase in risk of the economy, the reaction by the financial markets, including the foreign currency market, to the events so far has been moderate, at the time of writing. Nevertheless it is expected that an outcome of the events will be to raise inflation, at least in the short term.


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