Preliminary translation: 3.5.2010
Final version: 10.5.2010
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Inflation Report 2010, January-March
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
May 2010
This Inflation Report*, covering the first quarter of 2010, is submitted to the government, the Knesset and the public as part of the process of assessing the inflation rate in relation to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.
The CPI declined by 0.9 percent in the first quarter of 2010, mainly due to seasonal factors, but also reflecting government actions--the reduction in the VAT rate and the cancellation of the water surcharge--the cuts in electricity prices, and falls in housing and energy prices. In the previous twelve months the CPI rose by 3.2 percent, and the index excluding housing and energy by about 2.1 percent.
The recovery around the world which had started in the last quarter of 2009 continued, but not uniformly: in the advanced economies the modest recovery was based mainly on very heavy monetary and fiscal intervention, which cannot continue indefinitely but the duration of which will vary, depending on individual country circumstances. In the emerging market economies, however, growth was driven more by domestic demand from households and companies and increases in commodity prices. Inflation rates around the world are generally low, although in the emerging markets there are initial indications of a rise in inflation. Central banks in most advanced economies are keeping their interest rates at a low level, but some of them have started reducing the extent of their use of unconventional instruments.
In the Israeli economy, the recovery in real economic activity and the decline in unemployment continued in the fourth quarter of 2009. Growth was based on the increase in private consumption, which was partly driven by the low level of interest rates, and on the growth of exports, reflecting the effect of the expansion of world trade. Indicators relating to the first quarter of 2010, particularly the Bank of Israel Companies Survey for that quarter, show that business activity continued to increase.
During the first quarter of 2010 prices of financial assets--shares and corporate bonds--and house prices continued to rise. Around the world share prices also rose but somewhat more slowly then in Israel. The increase in share prices world wide and in Israel is due in part to the economic recovery and the expectation that it will persist, but it is certainly also partly the result of the low interest rates prevailing in most countries. Similarly the rise in house prices in Israel is also in significant part a result of low interest rates.
In the first quarter of 2010 the Bank of Israel continued the process of increasing the interest rate, which it sees as part of a process of gradual normalization of the rate. Thus the interest rate was increased from 0.5 percent in September 2009 to reach 1.25 percent in January 2010 and 1.5 percent in April 2010. The reasons for the increases were: the rate of inflation over the previous twelve months, which was above the upper limit of the target inflation range throughout the period; the relatively high level of one-year-forward inflation expectations, both those of forecasters and those derived from the capital market; the continued entrenchment of growth; and the continued increase in the prices of assets, including shares and houses. There were indications, however, that in the last quarter of 2009 and the first quarter of 2010 the rate of price increases in the domestic market moderated to some extent, and there were signs of a slowdown in economic activity in Europe, against the background of debt financing difficulties in several countries.
The nominal effective exchange rate of the shekel continued to appreciate, as it had in the period from April to December 2009, strengthening by a further 3.9 percent from December 2009 to March 2010. The Bank of Israel continued to intervene in the foreign currency market, with the intention of preventing excess appreciation in the effective exchange rate.
On April 21, the Bank of Israel updated its forecast of economic activity for 2010 and issued its first forecast for 2011. The Bank's assessment is that growth will be 3.7 percent in 2010, and that unemployment will continue to decline to reach an average for the year of about 7 percent. The rate of inflation is expected to moderate during the next twelve 12 month to about 2.2 percent. . For 2011, the forecast is for some further improvement in the real economy, and inflation near the midpoint of the target range. The Bank of Israel interest rate is expected to increase gradually during the remainder of this year. The real appreciation reflected by the effective exchange rate in the last eight months of 2009 and its continuation in the first quarter of 2010, and the level of GDP, which is still expected to be below its potential level--the effect of the global crisis on economic activity in Israel--are expected to contribute to the reduction of inflation.
The Bank of Israel will continue to monitor developments in Israel and abroad and implement a policy supportive of growth and financial stability, while striving to return inflation in the next twelve months to around the midpoint of the target range. At this stage the Bank assesses that it will increase the interest rate gradually, at a rate determined by the inflation environment, the entrenchment of growth in Israel and around the world, the development of shekel exchange rates and of asset prices, and interest rate adjustments by other central banks.

Stanley Fischer

Governor, Bank of Israel
* This report incorporates the report on the rise in the money supply, in accordance with section 35 of the Bank of Israel Law, 5714-1954: in each month from January to March 2010 (inclusive) the money supply exceeded that in the preceding twelve months by more than 15 percent. The change in the money supply is discussed in section 1d.

  Inflation: In the first quarter of 2010 the CPI declined by a total of 0.9 percent. Inflation in the quarter essentially reflected seasonal price reductions, and was also affected by government actions in 2010--the cut in the VAT rate and the removal of the water surcharge--the lowering of electricity tariffs, and the fall in the housing and energy indices. In the course of the quarter the annual rate of inflation moderated, and in March it reached 3.2 percent, close to the upper limit of the target inflation range. This inflation rate was mainly due to the increase in housing and energy prices, and the price increases that resulted from government decisions in 2009, and their smaller reduction at the end of 2009 and the beginning of 2010.
  The global economic environment: The recovery in the global economy continued. It was stronger than expected, but was not uniform: in the advanced economies growth was weak, and its future strength is as yet uncertain, because its main cause--extremely expansionary monetary and fiscal policies and unconventional tools--cannot continue. Growth in the emerging market economies is faster and sounder, as it is driven mainly by domestic demand and increases in commodity prices. The problem of heavy public debt in some countries, concern over a slowdown in growth, and risks to financial stability in several countries in Europe still cast a shadow over a return to normal global growth.
  Real activity in Israel: In the fourth quarter of 2009 the growth of real economic activity accelerated, and unemployment continued to fall. Growth was based to a large extent on private consumption and the increase in exports resulting from the expansion of world trade. The increase in demand halted the expansion of the negative output gap, and thus the moderating effect of the output gap on prices also weakened. Initial indications regarding the first quarter of 2010 point to a more rapid expansion of economic activity.
  The financial markets: In the first quarter of 2010 prices of financial assets continued to rise, and at an even faster pace, extending the positive trend that started after the recession at the end of 2008 and the beginning of 2009. This was in line with the upward price trend around the world, especially in the emerging market economies, and occurred against the background of the continued strengthening of real activity and the low interest rate in Israel.
  The exchange rate: Over the quarter as a whole the trend of appreciation of the shekel in terms of the nominal effective exchange rate continued, against the background of the surplus in the current account of the balance of payments and the positive difference in interest rates between Israel and other countries. The Bank of Israel intervened in the foreign currency market when the shekel appreciated abnormally; thus the Bank bought $1,573 million in January, $200 million in February, and $500 million in March.
  Monetary policy: In 2010:Q1 the Bank of Israel continued the process of gradually increasing the interest rate to a normal level appropriate to the new economic conditions, as the effects of the global crisis weakened. Thus it increased the interest rate by 0.25 percentage points in each of the months December 2009, January 2010, and April 2010, when it reached 1.5 percent. The Bank left the rate for May unchanged at that level. The increase in the interest rate was made possible by (1) the reduction in the risks of a continuation of the recession as growth became more firmly entrenched, (2) the rate of inflation that was above the upper limit of the target range, and (3) the stability of the financial system. The pace of increase in the interest rate was determined by several factors--actual and expected inflation; the exchange rate; asset prices; the pace of recovery in the global economy, the strength and maintenance of which are essential for continued growth in Israel; and the adjustment of interest rates around the world.
  The Bank of Israel forecast: The Bank of Israel's assessment is that the annual inflation rate will moderate in 2010, so that mid-year it will enter the target range, and in a year's time it will be 2.2 percent. The decline in inflation will continue due to the effective appreciation of the shekel in the last few months and the negative output gap that resulted from the impact of the global crisis on economic activity in Israel. The Bank forecasts growth of 3.7 percent in 2010, a decline in the unemployment rate to an average of 7 percent, and a narrowing of the negative output gap--all these expected to happen alongside the gradual process of increasing the interest rate .
* 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.)
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