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Inflation Report 2004, January - June
Governor's letter

Jerusalem, July 2004

The Inflation Report for the first half of 2004 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 targets set by the government, and is intended to increase the transparency of macroeconomic policy. The transparency of policy-both fiscal and monetary-is important as a means of increasing economic confidence of Israeli and foreign companies and individuals and contributes to the proper functioning of the markets and the economy as a whole.

The CPI (Consumer Price Index) rose by 1.4 percent in the first half of 2004, and in the twelve months to June 2004 it was unchanged. The rise in the CPI in 2004 and in the coming twelve months is expected to be within the price-stability target range of 1–3 percent determined by the government in August 2000. A fixed, continuous target, not per calendar year as was the case previously, enables policy to act at all times to achieve the target for the next twelve months, while allowing for temporary deviations in either direction in order to minimize fluctuations in the interest rate.

In the half year under review the rate of price increases rose towards the middle of the target range, against the backdrop of recovery in real activity that started in the second half of 2003 after two years of recession, and depreciation of the NIS against the dollar following its marked appreciation in 2003. Together with the rise in prices, inflation expectations also went up towards the middle of the target range.

During this period the Bank of Israel acted to attain the target of price stability, reducing the interest to as low a level as possible without adversely affecting stability, while constantly reviewing the indicators that guide its policy. Accordingly, the Bank’s interest rate was lowered by a cumulative 1.1 percentage points from the beginning of the year to April, when it reached 4.1 percent, and was kept at that level thereafter.

Economic developments in Israel were led to a large degree by the recovery of global demand, particularly for output of the high-tech industries, which helped to boost exports. The improvement in the economic environment was also supported by the relative quiet on the security front in the period, which resulted in a rise in investment, private consumption and imports. These were helped by the improved mix in macroeconomic policy, i.e., tighter fiscal discipline combined with monetary expansion, reflected by relatively low long-term and short-term real interest rates.

The cuts in government expenditure in line with the target set, together with a significant increase in tax revenues resulting from the recovery in economic activity, are expected to enable the government to meet the deficit target for 2004, which was raised to 4 percent of GDP. The government decision to reduce tax rates following the increase in tax receipts while still meeting the deficit target, instead of reverting to the original deficit target of 3 percent of GDP, will be reflected in the continued rise in the public debt/GDP ratio in 2004.

Government policy plays a major part in shaping the economic environment. Fiscal discipline considered by the public to be credible is also essential for the management of monetary policy. The public’s assessment that the government is staying within the budget and deficit framework is likely to be expressed in lower long-term interest rates, in lower short-term and longer-term inflation expectations, and in reduced uncertainty and reduced instability in the financial markets. In this way fiscal policy can enable monetary policy to maintain price stability at relatively low interest rates.

Over the last year the foreign-currency market was relatively calm, with some depreciation of the NIS against the dollar (in the first five months of the year, offset partially thereafter), some of which was the outcome of changes in cross-rates worldwide. Alongside the calm in the foreign-currency market, Israel's risk premium stabilized at a relatively low level, in line with a similar process in other emerging markets; the exchange-rate risk also continued falling. The changes in the exchange rate were affected by short-term factors on the one hand, including the narrowing of the interest-rate differentials and Israelis’ adjusting their portfolios, and by the persistent rising trend of capital inflow, against the background of the global economic recovery.

The developments in the foreign-currency market reflect the changes it has undergone over the last few years-liberalization that exposed the economy to short- and long-term capital flows, and the move to what is effectively a floating-exchange-rate regime. Such an environment, in which the markets react to changes in economic conditions and reflect them, emphasizes the importance of a responsible and credible macroeconomic policy, and thereby adds to its efficiency.

The removal of the ceiling on stock of issued Treasury bills at the end of 2001, combined with the increased use that the Bank of Israel makes of market instruments, including Repo transactions from the beginning of 2004, helps make monetary policy more effective, in other words, enables it to achieve its objectives with relatively modest fluctuations in the interest rate. This is because these instruments operate in the context of a wider market, thereby enhancing the policy’s transmission mechanism.

The main policy target for the next year and the following years is to maintain economic conditions that will enable the economy to realize its growth potential long term, with a rise in the rate of employment and a reduction in the degree of poverty. To achieve this the government must persist in following a fiscal policy consistent with the targets set-a maximum increase of one percent a year in government expenditure and a deficit of 3 percent of GDP-so that the government debt/GDP ratio will revert to the downward path it followed till the year 2000. Monetary policy will continue to operate to preserve price stability while maintaining financial stability at the lowest possible interest rate, and will thereby support a sustainable growth path. The observance of fiscal discipline and a falling government debt over the next few years will allow that to be attained at relatively low interest.

The policy to encourage continued growth while reducing poverty and increasing employment must center round a significant rise in investment in the infrastructure, with budgetary and extra-budgetary financing. Due to the extent, complexity and essential need for such investments, the government’s decision to centralize their handling in the Ministry of Finance must be implemented. At the same time steps must be taken that will boost employment directly: tax policy that will increase the incentive to work, including negative income tax; a significant reduction in the number of foreign workers, mainly via economic means; a real extension of the program for finding jobs for the unemployed; the development of services that will make it easier to go out to work; aid for small and medium-sized businesses, focusing on the aspect of management follow-up; and increased investment in education in areas and populations with particularly low rates of employment. These measures will complement those taken hitherto to reduce the incentives to stay out of the labor market-which are inherent in allowances paid to those of working age-and to reduce the number of foreign workers.

In addition to the above, the government should promote the reforms to increase competition in the economy, including reforms in the capital and money markets intended to encourage nonbank financial intermediation, as well as structural changes required to increase competition in the infrastructure industries.

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 Klein



The Consumer Price Index (CPI) rose by 1.4 percent in the first half of 2004 (the period reviewed), and over the twelve months to June 2004 it remained unchanged. The rise in the first half-year marks the return of inflation to the target range of price stability, following the 1.9 percent fall in the CPI in 2003.


Monetary policy in the period reviewed operated against the background of a trend change in the economic environment: a rise in inflation assessments and actual price rises to within the inflation target range, after they had been below the lower limit of the range in 2003; the depreciation of the NIS against the dollar, following its appreciation in 2003; and recovery in real economic activity that started in the second half of 2003, after the long recession.


In the first quarter of 2004 expected inflation for one year and two years forward rose to within the target range, and assessments regarding exchange-rate risk remained low. These developments supported continued cuts in the interest rate, but because of the cumulative reductions in 2003, at a slower pace than in the past.


In April and May expected inflation continued rising within the target range, as the CPI rose. Yield curves rose and their positive slopes became steeper, following their decline in 2003 which was due to the reduction in the deficit, against the backdrop of the rise in yields in the US, and possibly also related to the government’s use of surplus revenue to reduce taxes. The combination of changes in several indicators could indicate upward pressure on prices. These developments prompted the Bank of Israel to halt the process of interest-rate reduction.


The expansion of economic activity that had started in the second half of 2003 continued during the first half of 2004. The rise in GDP reflected an increase in exports, private consumption, and investment, while public consumption fell in the first quarter. The rapid increase in GDP serves to reduce the output gap. The background to the turnaround in activity was essentially the rising trend in global demand, combined with the improved security situation. It was also supported by a better mix of macroeconomic policy, expressed by a relatively low level of long- and short-term real interest rates.


The budget deficit in 2004 is expected to be 4 percent of GDP, in line with the target set in the Budget Law, despite the cuts in statutory tax rates decided upon in the first half of the year amounting to almost one percent of GDP; this is the result of the turnaround in real activity and the rise in tax revenues.


The foreign-currency market was relatively stable in the period reviewed, as a result of opposing forces offsetting each other-short-term factors that acted throughout most of the period to weaken the NIS, and long-term forces that acted to strengthen it. In the first quarter the exchange rate was affected mainly by domestic considerations, and in the second quarter, by global developments relating to the dollar.


Nonresidents’ activity in the fist half of 2004 consisted mainly of sales of foreign currency via long-term financial instruments, that was partly offset by purchases of foreign currency via short-term instruments. Israelis,  on the other hand, purchased foreign currency, mainly via long-term instruments, but also via short-term ones.

The full document, in PDF file -

Previous Inflation Reports:

   Inflation Report 2003 (July-December)
   Inflation Report 2003 (January-June)
   Inflation Report 2002 (July-December)
   Inflation Report 2002 (January-June)
   Inflation Report 2001 (July-December)
   Inflation Report 2001 (January-June)
   Inflation Report 2000 (July - December)
   Inflation Report 2000 (January - June)
   Inflation Report 1999 (July - December)
   Inflation Report 1999 (January - June)
   Inflation Report 1998 (January - June)
   Inflation Report 1997