Preliminary translation: 31.7.2007
Final version: 13.8.2007
The full document, in PDF file -

Inflation Report 2007, January - June
Letter of the Governor, Professor Stanley Fischer
July 2007
The Inflation Report for the first half of 2007 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 Report was prepared in the Bank of Israel under the auspices of the Senior Monetary Forum, headed by the Governor, the Forum in which the Governor makes decisions on the interest rate.
In the first half of 2007 (the period covered by this report), the Consumer Price Index (CPI) rose by a total of 1 percent. The inflation rate (CPI) over the twelve months ending June 2007 was minus 0.7 percent, significantly below the lower limit of the target range of price stability (between 1 percent and 3 percent rise a year). Rapid economic growth continued, with employment rising and unemployment falling.
The financial markets became more volatile in the first half of 2007, particularly the NIS/US$ exchange rate and the bond market, after several years of relative stability that had prevailed despite a series of shocks that could have undermined it. The upward trend in share prices and the increase in activity in the markets nonetheless persisted, with a rise in the volume of trading and new issues. The main factors behind these developments were the reforms in the domestic financial markets carried out over the last few years, fluctuations throughout the world--including the weakening of the dollar against most other currencies and the changing status of emerging markets in the international financial markets--and Israel's continued rapid real economic growth.
The market reforms were aimed at increasing the participation of large-scale foreign investors in the domestic markets and boosting the development of non-bank financial intermediation. It appears that these goals are being reached, with a rise in capital flows into, from and within the economy.
The volatility of the exchange rate caused fluctuations in the CPI too: inflation, viewed over the previous twelve months, was below the target range until May, but from mid-May and particularly in June the weakening of the shekel against the dollar and even more so against the euro returned the expected inflation environment to the middle of the target range, and possibly even close to its upper limit.
In the last two years Israel's inflation has been affected by conflicting forces. Both real economic growth and the fall in unemployment exert upward pressure on inflation; by contrast, the considerable current account surplus and the inflow of long-term capital tend to strengthen the shekel and to hold inflation down. It is difficult to assess the relative strength of these opposing forces or their overall effect on inflation at any point in time.
The continued appreciation of the shekel since August 2006, and in particular in April 2007, caused the CPI to fall, and prompted the Bank of Israel to reduce the interest rate gradually to bring inflation back into the target range. The cuts in the Bank of Israel's interest rate widened the differentials between the policy rates in Israel and the US and the other advanced economies, and resulted in a change in the path of the exchange rate in May, and in June the shekel weakened even faster. The impact of the exchange rate (of the shekel against the dollar) on inflation in Israel is closer even than that in other small open economies, in large part because the link between domestic prices of important non-tradables--particularly housing and rents--are specified in dollars, although paid in shekels. Thus a change in the dollar exchange rate has a substantial impact on the inflation rate within a period of a few months.
Despite the difficulty in hitting the targets precisely, the inflation targeting regime in Israel plays a decisive role in keeping long-term inflation in the low single digits. This, thanks to the existence of a clear target and the transparency of the central bank's interest rate policy that has succeeded in keeping inflation expectations around the center of the target over time. This stability, combined with fiscal discipline and a gradual well-planned process of structural reforms in the economy, has maintained an environment favorable to business activity, and has enabled sustainable growth to be maintained in its fifth successive year.
At the time of completing this report, the assessment of economic developments in the next year remains positive--persistent high real economic growth, surpluses in the current account, expectations that the inflation target will be attained, and financial buoyancy.
Nevertheless, at the time of writing (the end of July) we detect a certain deterioration in the balance of risks facing the economy, due particularly to concern over the continuation of stability in the international financial markets, for example in the markets for sub-prime mortgages and the consequent deterioration of credit conditions, to the difficulty in adhering to the strict framework of government expenditure as set out in the multi-year budget, and to geopolitical uncertainties. These risks accentuate the importance of sticking to a stable and transparent monetary policy regime that constantly strives to achieve the inflation target.

Stanley Fischer

Governor, Bank of Israel

  In the first half of 2007 (the period reviewed) the Consumer Price Index (CPI) rose by a total of 1 percent. Over the last twelve months the CPI has fallen by 0.7 percent, below the lower limit of the price stability target of 1-3 percent inflation a year.
  The main factor acting to restrain the rate of price increases in the first half of the year was the continued appreciation of the shekel against the dollar. Pressure in the opposite direction, i.e., acting to raise prices, came from the persistent rise in demand for domestic product and from the rise in prices of imported goods and in world energy prices.
  Economic growth continued in the period reviewed, and contributed to the further contraction of the output gap, but this had only a marginal effect on the price index due to the transmission from the exchange rate: the appreciation of the shekel offset much of the effect of the rise in domestic prices. The average nominal wage went up by about 3 percent in the last twelve months, and there was a slowdown in the rise of labor productivity. This means that inflationary pressure from the labor market could grow, as is suggested also by the change in the index of unit labor cost.
  The NIS/$ exchange rate did not follow a steady path in the first half of 2007: in the first quarter it moved without any clear direction. From the end of the first quarter until the middle of May the shekel appreciated rapidly, by about 6.5 percent. In mid-May the trend reversed, and the shekel depreciated at a similar rate.
  The pressure for appreciation of the shekel derived mainly from long-term domestic factors, in other words, the economy's positive fundamentals, including the current account surplus and capital imports. On the other hand, the change in the trend of the exchange rate resulted from the stronger effect of short-term factors, mostly domestic, and developments in the international financial markets, against the background of the large, negative interest rate differentials, especially vis-?-vis the dollar.
  The monetary policy conducted by the Bank of Israel in the period reviewed was aimed at returning inflation to the target range while preserving financial stability. The policy was reflected in cuts in the interest rate totaling 1.5 percentage points, following the reductions totaling 0.5 percentage points in the last two months of 2006. These brought the interest rate at the end of the first half of 2007 to 3.5 percent.
  The approach whereby the interest rate is reduced gradually was necessary because of the possible effects of sharp changes in the interest rate on the inflow of short-term capital and on the prices of financial assets. This, against the background of the widening of the negative interest rate differential between Israel and the US, which reached 1.75 percentage points at the end of the period reviewed.
  On the fiscal front, despite the increase in government expenditure, the persistent trend of rising income is expected to result in a deficit significantly below the ceiling. In 2008 the government will need to face the challenge of adhering to its commitment to keep the deficit below the ceiling, and thus maintaining the credibility of fiscal policy. This is even more important in the light of decisions taken in 2007 that increase public civilian expenditure.
Israel's monetary regime: The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, which since 2003 has been 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.)
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