The full document, in PDF file -

Inflation Report 2008, October–December
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
27 January 2009
The current period is one of uncertainty about economic developments in Israel: in particular significant risk factors relate on the one hand to inflation and on the other to economic activity. The main risk stems from the deteriorating and persistent global financial crisis. Here it should be noted that Israel is unlike many other countries in that its general financial system, and in particular its banking system, are well-placed to meet the global crisis. The Bank of Israel will continue to monitor the economic situation and assessments of expected developments around the world and in Israel, and will act to achieve price stability while supporting real economic activity and preserving financial stability.
The severity of the global economic crisis increased markedly in the middle of September 2008 when some of the largest and most important commercial banks and investment banks in the US and other advanced economies collapsed. Governments quickly introduced rescue plans to ensure continuity in the payment systems and reasonable functioning of the financial system. The crisis persists, with an increasingly severe slowdown in real economic activity world wide. Policy makers have adopted extensive measures, in many cases unconventional and unprecedented, geared towards easing the situation.
When the crisis erupted, Israel’s economy was in a relatively favorable situation after five years of rapid growth and low inflation, with the banking system in sound condition. In the fourth quarter of 2008, however, the ongoing global crisis began to have a dominant impact in Israel too as the CPI declined by about half a percent and GDP growth was near zero, following slowdowns in the previous two quarters. The combination of extremely low real growth and negative inflation in the fourth quarter substantiates the highly negative effect that the global economic crisis had on demand for Israeli product recently.
The negative inflation recorded in 2008:Q4 was to a great extent due to the drop in world oil and raw material prices, in contrast to their effect in the twelve months prior to that quarter. Local factors also contributed to price changes in the two periods: the economic boom contributed to the high inflation prevailing until the third quarter of 2008, while the sharp reversal of the economic situation in the last quarter supported price reductions. Housing prices, measured mainly by renewed rental contracts, rose in the fourth quarter, apparently because of the persistent downward trend in the stock of available apartments; the construction industry is the only one in which supply appears to have declined faster than demand, a feature reflected also in rising prices in sales of second-hand apartments.
The declines in economic growth and in inflation spurred a change in monetary policy. In the first three quarters of the year, inflation rose above its target range (defined as a rise of 1–3 percent in the CPI over the previous twelve months), due primarily to the continued increases in world raw material prices. Thus, the interest rate had to be increased, especially in the third quarter, even though as early as the end of the first quarter and in the second there were indications that Israel’s economy might be adversely affected by the global crisis. In light of these signs, the Bank of Israel had reduced the interest rate as early as end-February (i.e., the interest rate for March). The rapid and serious deterioration in the global economy from mid-September necessitated deep cuts in the interest rate, similar to steps taken by other central banks, and the Bank reduced the rate from 4.25 percent at the beginning of the last quarter to 1.75 percent in January 2009, and to 1 percent in February––its lowest levels ever.
The objective of these rate reductions is to support real economic activity and limit any deviation of inflation below target in light of the severe drop in demand and the fall in commodity prices in the last quarter of 2008, along with assessments that the slowdown will continue in 2009. This is in contrast to the situation of conflicting considerations prevailing upon the interest rate decisions from May to September, when inflation was above the target range but when there was concern over the slowdown in real activity.
The crisis, however, limits the effectiveness of interest rate policy alone: at the current rates, the ability of monetary policy to further boost demand for investment and private consumption is limited, mainly because of the increased risk premium on credit interest deriving from the economic crisis and concern over borrowers’ repayment ability.
Another instrument in the Bank of Israel’s arsenal is its purchase of about $100 million a day in the forex market. This enhances Israel’s resilience in the face of possible additional shocks by increasing the foreign exchange reserves. Augmenting the forex reserves assumes even greater importance, as small economies such as Israel’s, freely open to trade in goods and services and in the financial markets, are very exposed to the possibility of strong international capital flows in reaction to shocks abroad and domestic shocks, both economic or financial, and geopolitical.
Entering 2009, there is great uncertainty regarding developments in the coming year and beyond: there may be further, even significant, deterioration in the situation, but there are also assessments that some improvement in the global environment is possible as early as the second half of 2009, in which case the economic decline in Israel would likely be more moderate than that in other countries. The Bank of Israel will continue to employ the instruments available to it with the purpose of minimizing the impact of the imported crisis on real activity and employment, while returning inflation to the target range.

Stanley Fischer

Governor, Bank of Israel

  The rate of inflation changed sharply in the last quarter of 2008, with the CPI falling by 0.6 percent. Seasonally adjusted, the index did not change in the fourth quarter, compared with annual rates of increase of 6 percent and 7 percent in the second and third quarters respectively. Among the reasons for the change in the development of prices were the falls in prices of food, fruit and vegetables and energy, which offset the continued rise in housing prices. Over the whole of 2008 the CPI rose by 3.8 percent, above the upper limit of the inflation target range of 1–3 percent a year. The index excluding energy, food, fruit and vegetables and housing rose by 1.8 percent in 2008, close to the midpoint of the range.
  In the fourth quarter the slowdown in real economic activity in Israel became more severe in light of the worsening of the global crisis and expectations of its further deterioration. Central banks and governments around the world took unprecedented expansionary measures in the fourth quarter, intended to moderate the drop in demand and to reestablish confidence in the financial systems and capital markets, but the level of risk remained high, unemployment was expected to deepen further, and GDP to fall in most of the advanced economies. These developments greatly eased upward pressure on prices, caused a decline in commodity and food prices, and to a reversal in the path of inflation in Israel.
  In the last quarter of 2008 the Bank of Israel cut the interest rate five times (including twice in inter-meeting decisions), from 4.25 percent to 1.75 percent, and at the end of January reduced the rate to 1 percent, its lowest levels ever. It did so to moderate the effects of the global financial crisis on real economic activity in Israel, on the availability of liquidity, and on the stability of the financial system. The slowdown in the rate of actual price rises and the assessment that the upward pressures on prices evident during the year had eased greatly made it possible to attempt to achieve the inflation target and to support real activity by means of an expansionary monetary policy, which also helped deal with the credit shortage. Nevertheless, as a result of the increased risk in the markets around the world and in Israel, the rates of interest confronting the business sector rose, as reflected by the corporate bond market.
  The Bank of Israel forecasts are of a rapid fall in the rate of inflation and its entering the inflation target range (measured over the previous twelve months) as soon as in the first or second quarter of 2009. Due to the sharp turnaround of inflation, the deepening of the crisis, the slowdown in economic activity, and the steep fall in commodity and energy prices, inflation in 2009 is expected to be below the lower limit of the target range, and possibly even negative in the second half of the year.
* The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, 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.)
The full document, in PDF file -
To Inflation Reports page