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Governor's letter
The Inflation Report for the first half of 2003 is submitted to the government, the Knesset, and the public as part of the process of monitoring the course of inflation and adhering to the inflation targets set by the government, and is intended to increase the transparency of macroeconomic policy. The transparency of policy-both fiscal and monetary-is an important component of the increased certainty needed by economic agents, and foreign and Israeli investors in particular.
In August 2000 the government decided to adopt a path of inflation targets for the coming years, setting the target for 2003 and subsequent years at an annual 1–3 percent, defined as price stability. Accordingly, the object of monetary policy is no longer to attain a target defined by a calendar year but rather to attain it within the next twelve months on a continual and constant basis. This allows for temporary, short-term deviations in either direction in order to minimize interest-rate fluctuations. Temporary deviations may occur because price stability depends on additional factors, such as further information regarding the budget deficit, short-term movements in the foreign-exchange market, shocks in global markets, and shifts in the security situation-the effects of which cannot be offset in the short run by interest-rate policy.
The CPI (Consumer Price Index) declined by 0.5 percent in the first half of 2003, and by 0.3 percent in the last twelve months. The main factor underlying the moderation of price increases in the first half of the year was the significant local-currency appreciation. The contribution of this factor was expressed most notably in housing prices, which have fallen by 6.4 percent in the last six months, and by 10.9 percent in the last twelve months. Excluding the housing component the CPI rose by 1.3 percent in the last six months, and by 3.0 percent in the last twelve months. The continued slump in real economic activity-now in its third year-which results from security difficulties and the global recession, also contributed to the moderation of price increases.
The monetary policy in effect since mid-2002 has supported a return to price stability, after deviation from that path in the first half of 2002. The rate of price increases in 2003 is now expected to be below the lower limit of the price stability target. Nonetheless, in the next twelve months (July 2003 to July 2004) the rate of price increases is expected to be consistent with the target, partly because of assessments that the NIS is not expected to continue to appreciate as it has in the last twelve months. In view of the exceptional developments in the foreign-currency market in 2002, there was local-currency appreciation of 10 percent against the dollar between June 2002 and June 2003.
The first two months of 2003 were characterized by considerable uncertainty, in the context of the geopolitical conditions prevailing at the time and apprehensions that the government would be unable to attain its deficit targets. These conditions were reflected in the deterioration of indicators of the inflation environment, and local-currency depreciation and the rise in inflation expectations in particular. In and after March, with the announcement of the new government's economic package, the authorization of the US government guarantees, the conclusion of the war in Iraq, and renewal of the peace process, there was marked improvement in all the indicators of the economic environment. This was expressed inter alia in local-currency appreciation, which was largely influenced by the notable increase in the local-currency activity of nonresidents-due to the reduction in Israel's country risk and as part of a global trend of increased capital flows to emerging economies-as well as by the decline in inflation expectations and long-term interest. These trends made it possible to renew the process of reducing short-term interest. This was implemented gradually, making it possible to review changes in the background conditions and inflation environment and avoid imperiling the stability of the markets, which affects that of the economy as a whole.
The positive developments in the money markets are overshadowed by the budget deficit, which will apparently amount to 6 percent of GDP-considerably above the 3 percent target set for 2003. The government's economic package contains elements intended to act to reduce public spending in the medium term, thereby supporting the reduction of the budget deficit and the government debt in the future. Without additional policy measures, however, the deficit will not decline to the extent required in 2004 either.
The main target of policy for the next and subsequent years is to restore the economy to a sustainable growth path, making it possible to expand employment, reduce unemployment, and combat poverty while maintaining economic stability, including price stability. The focal point of this policy should be a concerted endeavor to reduce the number of foreign workers and substantially increase infrastructure investment. The effort to combat poverty and increase employment should center on improving classification and placement mechanisms, augmenting vocational training, and introducing other measures aimed at encouraging employment-in addition to the changes already made in national insurance benefits. Bringing the cost of employing foreign and Israeli workers into line with one another is essential in order to bolster employment of the latter. A massive increase in infrastructure investment requires special preparations on the part of the government for drawing up an adequate stock of projects for implementation, most of them extra-budgetary, as well as ensuring that appropriate sources of long-term finance are available.
In order to attain the policy targets a fiscal policy is required that will ensure a return to a declining deficit path, supporting the continuation of the positive trends in the financial markets, among them a decline in long-term interest. This policy, expressed in the reduction of the government's borrowing requirements, is a necessary precondition for providing the financing needed to expand infrastructure investment, which is an essential component of the policy designed to foster growth.
Monetary policy will act to maintain price stability at the lowest interest rate possible to also stimulate real economic activity without jeopardizing financial stability. A return to the declining deficit path will enable the establishment of price stability at a lower nominal interest rate than would be possible otherwise. This will enable real expected short-term interest to be reduced over time in order to boost economic activity.
This Inflation Report was prepared at the Bank of Israel within the framework of the Senior Monetary Forum. The Forum-headed by the Governor-is the inter-departmental team (whose members include the Deputy Governors and the heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Activity Departments) within which monetary policy issues are discussed.
David KleinGovernor
Summary
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The Consumer Price Index (CPI) declined by 0.5 percent in the first half of 2003, after increasing by a moderate 0.2 percent in the second half of 2002. In the last 12 months the CPI has dipped by 0.3 percent. In the absence of exceptional events, the rate of price increases in 2003 as a whole is expected to be below the lower limit of the inflation target (1-3 percent). In the next 12 months the CPI is expected to rise at a rate that is consistent with the inflation target range. |
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As of 2003 the inflation target is not defined on the basis of the calendar but rather as a continuous and constant target of price stability (1-3 percent), so that at any point in time the aim of policy is to attain it within the next 12 months. Thus, temporary, short-term deviations-in either direction-are permitted from the rate defined as price stability, in order to minimize interest-rate fluctuations. |
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The main factor moderating price increases in the first half of 2003 was local-currency appreciation. One aspect of this was that the CPI adjusted for the decline in housing prices rose by 1.3 percent in the first half of 2003, and by 3 percent in the last 12 months. The continued recession also contributed to the environment of a low rate of price increases. The continued slump in demand was due primarily to the security-political situation and the global slowdown. The tight monetary policy evident since the middle of 2002 served to slow the rate of price increases in several ways, i.e., by fostering local-currency appreciation and dampening both demand and inflation expectations. |
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In the first two months of 2003, in view of the expected war in Iraq, which increased Israel's geopolitical risk, and the public's apprehensions regarding the government's ability to attain its deficit targets, all the indicators of the inflation environment and uncertainty deteriorated. In order to help restore stability to the markets, the Bank of Israel left its key interest rate for February and March unchanged. |
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In March-July the indices of the inflation environment and uncertainty rallied, as a result of the announcement, and approval by the Knesset, of the new government's economic package, the authorization of the US government loan guarantees, the rapid conclusion of the war in Iraq, and the revival of the peace process. During this period long-term interest declined, the NIS rallied, and share prices rose. Against this background, assessments that the inflation target would be attained in 2003 and that financial stability would be maintained became firmer, so that the Bank of Israel reduced its key interest at an increasing rate. In 2003:II short-term interest was lowered by a cumulative 0.9 percentage points, and the July interest rate was cut by an additional 0.5 percentage points, bringing it down to 7.5 percent. |
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Even after the introduction of the economic package, the budget deficit in 2003 will probably be considerably above the 3 percent of GDP annual target, and is now expected to be 6 percent of GDP. Unless further policy measures are introduced it is expected to remain at a similar level in 2004, too. Nevertheless, if the economic package is implemented in full it is expected to reduce the budget deficit in the longer run, making a gradual trend decline in the government debt possible. This can be achieved if government expenditure continues to be reduced. |
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Foreign-currency activity in the first half of 2003 was affected by substantive changes in Israel's country risk. From the end of 2002 until mid-February both country and currency risk rose, and the NIS weakened. After the end of February the risk declined rapidly due to the various positive developments mentioned above. Against the backdrop of the interest-rate differential between Israel and abroad, and despite the reduction of the Bank of Israel's key interest rate, the decline in risk helped to strengthen the NIS. The fall in Israel's country risk occurred in the context of a global reduction in the risk of emerging markets since the end of 2002, with increased capital flow to them. |
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Nonresidents contributed notably to the strengthening of the NIS by increasing their short-term sales of foreign currency in and after February, primarily via future transactions. The business sector bought large amounts of foreign currency from nonresidents, alongside a decline in exchange rates, and utilized it to reduce its exposure to local-currency depreciation and repay foreign-currency credit. Households continued to purchase foreign currency-albeit to a smaller extent than in the first half of 2002-but this trend ceased in 2003:II. In the first half of 2003 there was some improvement in Israel's current account. |
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Monetary policy aims to maintain price stability in line with the long-term inflation target (1-3 percent) at the lowest interest rate that is consistent with this target, thereby contributing to the revival of real economic activity. Both the continuation of the process of reducing interest in the coming months and the pace at which this is done, depend on the development of other factors which affect inflation. Short-term interest will be lowered gradually, making it possible to assess the changing conditions and adjust interest to them, thereby avoiding imperiling the stability of the financial markets and the economy in general. The convergence of the budget deficit to a path that enables the reduction of the government debt/GDP ratio, expressed in the continued downward trend of long-term interest, will make it possible to maintain price stability at a lower short-term interest rate. |
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