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Inflation Report 1
Governor's letter
Bank of Israel
15 March 1998

  The Inflation Report is submitted for the first time to the government and the public, with the intent of establishing periodic monitors of inflation and attainment of the inflation targets set by the government. The Bank of Israel attaches great importance to regular reporting and discussion of this subject in order to enhance the transparency and credibility of monetary policy. This will better enable monetary policy to continue reducing inflation, to reach levels acceptable in the West by the beginning of the next decade, and to maintain price stability over time, in accordance with the government's decisions. Attaining and maintaining price stability are crucial for achieving sustainable growth of output and employment.
  Increasing the transparency of policy aims and of policy results is very important for both the public in Israel and international financial markets. In the last few years, participants in these markets have displayed growing interest in the potential of the Israeli economy. This has been reflected in Israel's improved financial standing as well as by the continuous stream of direct and portfolio investments from abroad, which peaked in 1997.
  Progress in the globalization of world markets provides a challenge for Israel. Successful integration in the world economy obliges us to ensure attainment of policy objectives in the areas of fiscal and monetary policies and the liberalization of capital markets. At the same time, it is vital to continue to promote structural reform and the advancement of our competitive position.
  This report demonstrates the importance given by the Bank of Israel to an open account of monetary policy adopted to attain the inflation targets set by the government. Favorable conditions have now been created for more rapid progress in the struggle against inflation without intensifying monetary restraint. A commitment to continued stability of the Israeli economy is an essential ingredient of the overall policy promoting stable growth.
  The Inflation Report was prepared at the Bank, in conjunction with the Monetary Forum at the Bank of Israel, headed by the Governor of the Bank. The Monetary Forum is the senior interdepartmental team that makes monetary policy decisions.

Jacob A. Frenkel
Governor of the Bank of Israel


  In 1997 the Consumer Price Index (CPI) rose by 7 percent, a rate equivalent to the lower limit of the inflation target for the year, 7-10 percent; thus the annual target was attained. This target was set by the government at the end of 1996, along with the decision that "the target for the year 2001 shall be the rate accepted in the OECD countries." In setting the inflation target for 1998, the government also noted that it would aspire to "long-term price stability, as accepted in industrialized countries" (see Appendix 1).

  Several developments contributed to the attainment of the inflation target in 1997:

  • The Bank of Israel key interest rate adjusted for (market-based) inflation expectations averaged 5 percent, compared with 4.2 percent in 1996. The rise in the real interest rate was a result of inflation expectations falling faster than the decline in the nominal value of this key rate. Inflation expectations declined from an average of 11.6 percent in 1996 to 9 percent in 1997, while the Bank of Israel reduced its key rate from 15.2 percent in December 1996 to 13.4 percent in December 1997. The reduction of the key rate was made in the framework of the regular internal monthly reviews, and in accordance with the Bank of Israel's feasibility assessment of attaining the inflation target. The purpose of these monthly reviews is to analyze the state of the economy, taking into account the lag with which monetary policy affects inflation.

  • There was a turnaround in fiscal policy this year: the government met the budget deficit target while slowing the expansion of public consumption. The total government deficit was 2.4 percent of GDP in 1997, compared with a target of 2.8 percent, after substantial deviations from the target in the previous two years, particularly in 1996. These measures reduced the current account deficit on the balance of payments in 1997 to 3.6 percent of GDP, from an unsustainable 5.5 percent of GDP in 1996, supporting the policy of attaining the inflation target.

  • Alongside the rise in unemployment reflecting an overall economic slowdown, the slowing of GDP growth to approximately 2 percent made it possible to attain the inflation target without significantly intensifying monetary restraint. The turnaround in fiscal policy coupled with the fact that monetary policy was geared to attaining the inflation target contributed to the damping of activity. However, there were other important factors behind the decline in the growth rate and the rise in unemployment, chief among them structural changes in the economy, namely the contraction of traditional industries, whose workers are unable to move to expanding high-tech industries, which are short of skilled labor; the decline in immigration to Israel, and the damage to tourism as a result of the security situation.

  • The decline in world prices also created favorable conditions for slowing the increase in the CPI in 1997.
      The attainment of the inflation target in 1997, and the 3.6 percentage-point decline in the rate of price increases, compared to 1996, in the context of the monetary and fiscal policies and other economic developments, created an opportunity to make further progress in reducing inflation. This is in line with the government's resolutions regarding the long-term goal of price stability, common in advanced economies, that will enable the country to fulfill its growth potential. In order to achieve this, fiscal and monetary discipline must be maintained, i.e., it is necessary to continue reducing the budget deficit, in accordance with the government's decision, and to ensure that the development of interest rates and the money supply are consistent with the declining trend of inflation. This should go hand in hand with the constant monitoring of the conditions prevailing in the economy, and adjusting policy where necessary. The continued institution of structural changes, making Israel more competitive and the allocation of resources more efficient, will enable monetary policy to attain the inflation target at a lower interest rate.
1. Introduction

  Reducing the inflation rate is crucially important: price stability is one of the preconditions for sustainable growth, the efficient allocation of real sources, and the reduction of distortions in the distribution of income. A low level of inflation reduces economic uncertainty, thereby acting to extend the horizon of business decisions and encourage real investment (in machinery, equipment, and buildings).
  Furthermore, as long as Israel's inflation rate is higher than that of its principal trading partners, its competitiveness is impaired-an important consideration in an economy like Israel's which is small and open to international trade. As Figure 1 shows, inflation in Israel is still higher than in any of its principal trading partners.
  Inflation also plays an important part in determining Israel's financial ranking, which reflects the opinion of the international financial markets regarding the way Israel's monetary, fiscal, and structural policies are conducted. In an era of globalization, experience shows that the international markets often 'punish' countries that try to sacrifice long-term goals to short-term achievements, while rewarding more stable economies by means of extensive direct investment.
  There is a growing appreciation in the world that it is not possible to achieve long-term growth and employment by accepting high rates of inflation. Many countries have consequently chosen to reduce inflation even if this involves a real short-term burden (because of the uncompetitive structure of the economy), and to maintain price stability afterwards. A growing number of countries have decided that the best way of doing this is by setting inflation targets.
  Recognizing the need to integrate successfully into the increasingly globalized and open world economy, the government of Israel also decided to adopt a strategy of gradually reducing inflation to attain price stability, as is the practice in the West.
  Accordingly, inflation targets have been set in Israel since 1992. These have had an important role to play in making monetary policy transparent and credible, in planning the government budget, and in determining nation-wide wage agreements. A credible inflation target becomes a nominal anchor, molds inflation expectations, and brings them into line with the target. This affects the behavior of economic agents, thereby helping to reduce the cost of the disinflation process.
  In December 1996, the government in consultation with the Bank of Israel decided that Israel's inflation rate should be in line with that of the OECD countries by the year 2001. The target set for 1997, 7-10 percent, was in line with the policy designed to reduce inflation gradually over the next four years. The government also decided that the inflation target for each year would be set by the middle of the preceding year, before the discussions on the government budget. In August 1997, the government set a target of 7-10 percent for 1998 and decided to continue with the plan of reducing the inflation rate gradually in order to attain long-term price stability.
  Although specific annual inflation targets have not yet been set for each of the years 1999-2001, the government's decisions reflect its intention of gradually reducing inflation. Figure 2 shows the required inflation environment for each year until 2001, assuming that inflation in the OECD countries is to be about 4.5 percent in 2001.
  In many countries, the view is that the comparative advantage of monetary policy is to reduce inflation, and that herein lies its potential contribution to stable growth. This view is reflected in the definition of the central bank's task to achieve and maintain price stability, and it is given independence in deploying the instruments required to attain those aims. This institutionalization of the role of the central bank is accepted not only in western Europe but also by several countries in eastern Europe, South America, and Asia, many of which have adopted a low inflation target (up to 3 percent a year) or have decided that the goal is price stability.
  The purpose of the Inflation Report is to create a framework for monitoring and analyzing price developments, the inflation environment, and the factors influencing them, in order to evaluate the results of past policy as well as the measures that must be taken in the future. This framework will make the policy of attaining the inflation target, and especially monetary policy, more transparent. In an inflation target regime, it is very important to monitor the development of inflation and provide a mechanism for monitoring monetary policy which is clear to the public, operating alongside the mechanism for monitoring the implementation of the budget. The current report analyzes the development of inflation in Israel in 1997 with regard to the target attainment and the chances of achieving the appropriate inflation environment in the coming years.

2. The development of inflation in 1997

(1) The Consumer Price Index
  In 1997, Israel's inflation target was attained and the rate of price increase fell to a one-digit figure. The CPI rose by 7 percent, the lower limit of the inflation target for the year (7-10 percent) - 3.6 percentage points below the 1996 rate.
  According to the annual rates of change, the development of inflation shows that from the second half of 1996 until June 1997 there was a slowing of the rate of CPI growth, and a wide fluctuation of inflation between June and October, but in the last two months of the year the declining trend was evident again (Figure 3).
  Figure 4 shows the monthly path of price increases that is consistent with attaining the 7-10 percent inflation target and takes into account the seasonal element in price increases. The CPI rose at a cumulative rate close to the upper limit of the seasonal inflation path during most months of 1997, and at an even faster rate in many months. During the first eight months of 1997, the annual inflation rate was 9.8 percent. There was a significant slowing in the rate of price increases during the last four months of the year, while in November and December it even decreased cumulatively by 0.6 percent, bringing the annual inflation rate down to 7 percent.

(2) The development of the CPI components
  As Figure 5 shows, the rate at which the CPI rose in 1997 reflects price increases in all its components, apart from clothing and footwear which fell by 4.4 percent continuing the trend of their relative decline as a result of exposure to competing imports. Most components of the CPI rose by more than the CPI as a whole. This was particularly the case with health and education, culture and entertainment whose prices increased by 9.2 and 8.6 percent respectively. Food prices also rose by a significant 8.4 percent.
  Although the index of housing prices rose more moderately than in previous years (7.5 percent), it contributed almost 2 percent to the rise in the CPI because of its large weighting. The rise in the index of owner-occupied housing, reflecting inter alia the demand for housing for investment purposes, was slightly smaller than that of the index of housing prices, 7.2 percent, while the index of rents, which tends to reflect the demand for housing services, went up by 9.8 percent-a real rise of approximately 1.5 percent.
  All the components of the CPI (except for fruit and vegetables) rose by less in 1997 than in 1996. The moderation of increases in the prices of housing and health were particularly notable in 1997.
  Although the index of housing prices rose more moderately than in previous years (7.5 percent), it contributed almost 2 percent to the rise in the CPI because of its large weighting. The rise in the index of owner-occupied housing, reflecting inter alia the demand for housing for investment purposes, was slightly smaller than that of the index of housing prices, 7.2 percent, while the index of rents, which tends to reflect the demand for housing services, went up by 9.8 percent-a real rise of approximately 1.5 percent.
  All the components of the CPI (except for fruit and vegetables) rose by less in 1997 than in 1996. The moderation of increases in the prices of housing and health were particularly notable in 1997.

(3) Other price indices
  In a small, open economy such as Israel's where the tradable component in products and factors of production is large, the exchange rate and import prices affect domestic prices in the short run. This is usually indicated by dividing the components of the CPI into goods which are traded and those which are not1. Despite the problematic nature of this division, it is worth noting that in 1997 the prices of tradable and nontradable goods rose by 5.8 and 7.7 percent respectively.
  Since the CPI is affected inter alia by seasonal and transitory factors, many attempts are made to examine the development of various indices, such as the wholesale prices of industrial output, or the CPI excluding certain components. These indices are supposed to be less affected by random factors and thereby more reliable to indicate the future path of inflation, 'underlying inflation.' However, statistical tests show that in the last few years the various adjusted indices are not reliable indicators of the trend of the CPI, which is the target and Figure 6 shows that the various indices do not adequately track the CPI. Nonetheless, in 1997 the wholesale prices and the CPI, excluding housing and fruits and vegetables, rose by slightly less than the overall CPI by 6.5 and 6.7 percent respectively.

1 The distinction between goods that are and are not tradable is not clear-cut, and is based on the weight of the traded element in the product. For details, see I. Ben-Bassat, 1990, "Indicies of Tradable and Nontradable Goods", Bank of Israel Discussion Paper 89.11 (Hebrew).

3. The inflation environment and factors behind price developments

(1) The inflation environment
  The inflation environment in relation to the inflation target is one of the main factors affecting the decisions of monetary policy makers. The assessment of this environment is based on various elements, including a combination of the past and expected annual inflation rates, thus summing up the inflationary forces that were instrumental in the past and those still expected to have an effect. Econometric tests show that expectations of inflation have a significant and positive effect on actual inflation, and are themselves affected by real economic factors (e.g., unemployment), inflation during the preceding twelve months, and monetary policy, which is expressed by the expected real interest rate2. The assessment of the inflation environment is important for determining current policy, as monetary policy does not have an immediate effect, but operates with a lag of several months.
  Regarding the various factors discussed below, one will observe that the inflation environment in 1997 was lower than in 1996, remaining within the limits of the inflation target for most months.

2 For details, see D. Elkayam, "The effect of Monetary Policy on Expectation, 1988-95", Monetary Review, 4, 1996, Monetary Department, Bank of Israel (Hebrew).

(a) Inflation expectations:
  One of the main indicators of inflation expectations for the next 12 months is derived from the capital market (from the yield gap between Treasury bills and indexed bonds). After a clear declining trend in the second half of 1996 from a level of 13.5 percent, expectations settled within the range of the target at an average level of 9.2 percent in 1997 with considerable volatility, as was the case with that of actual inflation (Figure 7). During the first half of the year, after the exchange-rate band changes and significant local-currency depreciation, the monthly CPI levels were relatively high so expectations (for 12 months) rose too, approaching the upper limit of the target range, approximately 10 percent. At the end of the year in the context of November's negative CPI, they fell again to an environment of 8 percent. This indicates that expectations of inflation derived from the capital market are affected to a considerable extent by the development of actual inflation. However, these expectations also depend on the public's perception of present and future monetary policy, and its assessment of how firm the central bank is in adhering to its declared policy of attaining the inflation target. The fact that expectations remained within the inflation target range of 7-10 percent in 1997 is consistent with the view that the public perceived the target as credible. The persistent reduction of actual inflation will enhance the credibility of the disinflationary process, which also will continue to be reflected in expectations.

(b)The composition of the asset portfolio in the context of the public's assessment of the inflation environment:
  The public is ready to switch from indexed to unindexed assets in an economy where there is growing public confidence in the creation of a lower inflation environment, and in the determination of policy makers to take the necessary steps to achieve price stability. In 1997 the amount of unindexed assets in the public's asset portfolio continued to rise (Figure 8), as well as the unindexed local-currency share of the government's internal debt. The unindexed local currency deposits continued to grow this year; they increased by 24 percent from the beginning of 1997. The continued growth of unindexed local-currency deposits, as well as the share in them of long-term deposits (for more than a year), which rose from an average of 7 percent in 1996 to 8.5 percent, supports the assessment regarding expectations of declining inflation and its lower variance. Nevertheless, unindexed local-currency deposits for terms of up to three months have constituted 80 percent of all unindexed deposits for the last three years, indicating that the public is still uncertain as to whether prices will be stable in the long run. Moreover most of the government debt, is still indexed to the CPI, and indexation is still prevalent in Israel.

(2). Monetary policy and portfolio assets

(a) Monetary policy:
  The Bank of Israel's interest rate, the operative target of monetary policy, is determined after a comprehensive review of actual inflation, inflation expectations, the money supply, and other important factors, principally fiscal policy and real economic developments. The interest rate affects inflation via the transmission mechanism3, which comprises several channels: interest rates in the money and capital markets, the money supply, inflation expectations, the exchange rate, prices of assets, etc. The long-term analysis of these factors is intended to examine the transmission mechanism and to assess progress toward attaining the government's inflation target. There is a significant and negative correlation, with a lag, between the Bank of Israel's interest rate and inflation. This is indicated by econometric tests and is consistent with international disinflation experience.
  Since August 1996, the Bank of Israel's nominal interest rate has declined steadily from approximately 17 percent in July 1996 to 13.4 percent by the end of 1997 (Figure 9)4. In July 1997, the interest was the lowest recorded this year after being reduced by 1.2 percentage points in June. It was increased by 0.7 percentage points in September, and then kept stable until the end of the year. The expected real interest rate (based on expectations derived from the capital market) averaged 5 percent, above the 1996 average (4.2 percent). Despite the reduction of nominal interest, the rise in real interest is due to lower inflation expectations in 1997 than in 1996 - down from an average of 11.6 to 9 percent. The higher real interest rate evident since mid-1996 helped to moderate price increases in 1997.
  The principal instrument used by the central bank to conduct its interest-rate policy in 1997 was the auction on banks' time deposits with the Bank of Israel. These deposits soared in the first half of 1997, and stood at NIS35 billion by the end of the year. This rise was due to the Bank of Israel's absorption via these auctions, in order to sterilize the increased liquidity resulting from its purchases of foreign currency from the private sector. The purchases were undertaken in the framework of the Bank's commitment to defending the borders of the exchange-rate band, as is required by the current exchange-rate regime.

3 For details, see Developments on the Money and Capital Markets, 1996, Chapter2, Bank of Israel Monetary Department, and Bank of Israel Annual Report, 1996, Chapter7.
4 The interest the Bank of Israel pays to banks on monetary time deposits has developed in a similar way.

(b)The development of the monetary and credit aggregates:
  M1 (cash in the hands of the public and demand deposits) is the most important of the various monetary aggregates for determining monetary policy in Israel. This is so because it is the one most closely allied with prices, interest rates, and economic activity. Tests show that in Israel5 there is a positive correlation between the expansion of the money supply beyond GDP growth and the development of prices with a lag of two or three quarters (Figure 10). Controlling the money supply (M1) by means of the interest rate is one of the ways that monetary policy influences inflation. Figure 11 shows the negative relation between the Bank of Israel's interest rate and the money supply.
  During 1997, the money supply grew by 15 percent, a higher rate than actual nominal GDP. Nonetheless, the decline in inflation expectations during that period could have contributed to the greater demand for money. The interest-bearing local-currency aggregates expanded in 1997 by more than 23 percent, more moderately than they have in recent years.
  Total nondirected credit grew by 16 percent in 1997 compared with 20 percent each in 1995 and 1996 with greater variance in its components. Unindexed local-currency credit rose by 10 percent, CPI-indexed credit by 12 percent, and credit in and indexed to foreign currency expanded by 24 percent (in local-currency terms). Reflected in significant foreign-currency conversions by the private sector, most of this expansion occurred during the first half of the year, while the exchange rate against the currency basket stuck to the lower limit of the band. The widening of the band and the volatility of international yields significantly altered the behavior of the private sector. In the second half of the year credit in and indexed to foreign currency remained relatively stable (see more detailed discussion in the exchange rate section). The continued expansion of indexed local-currency credit, which rose by about 13 percent in 1997, is also in line with growing public confidence in the Bank of Israel's ability to prevent inflation from accelerating.

5 E. Azulay and D. Elkayam, "The Effect of the Development of the Quantity of Money on the Rate of Inflation in Israel, 1987-94, Economic Quarterly, April 1996. (Hebrew), and L. Leiderman and G. Bufman, "Monetary Policy and Inflation in Israel", discussion paper at the conference on Inflation and Disinflation in Israel, June, 1997.

(c)The inflation in prices of assets, and capital market developments:
  The effect of the interest rate on prices of assets is an important channel in the transmission mechanism through which monetary policy influences inflation, especially via the way changes in asset prices affect the wealth of the public, and hence private consumption. Asset prices are, however, also affected by other factors some of which are connected to general economic developments such as expectations of GDP growth and of increased profits.
  The stock market was characterized by a general rise of 35 percent in the share-price indices in 1997, with a clear upward trend until July, and a subsequent fall accompanied by high volatility (Figure 12). This rise may embody the wealth effect, possibly finding future expression in increased private consumption.
  On the indexed bond market, the decline in yields evident since mid-1996 persisted in the first half of 1997, and these stood at 3.8 percent (annual average) in August 1997 (Figure 13). In the second half of the year especially toward the end, there was an upward trend in yields. This appears to be connected with the fall in the demand for indexed bonds as investors shifted to unindexed assets indicating public assessments that inflation would decline. (The sale of Bank Hapoalim and the subsequent temporary reduction in the demand for indexed bonds also served to increase the yields on bonds: the expansion of credit by the banks to finance the purchase reduced their ability to invest in bonds.)
  The yield on Treasury bills depends mainly on the public's expectations of changes in the inflation environment and in short-term nominal interest. The yield curve of Treasury bills declined in the first half of the year in comparison with 1996, below 13 percent (Figure 14). The decline in the yields is linked with the lower nominal interest and expected inflation than in 1996. In the second half of the year, the negative slope of the yield curve steepened, apparently reflecting expectations that nominal interest would continue to decline and that inflation would moderate.

(3)Exchange-rate policy and capital flows

  The parameters of the crawling exchange-rate band and the actual development of the exchange rate play an important role in the transmission mechanism by which monetary policy operates to attain the inflation target. The lower the rate at which the nominal exchange rate rises, the smaller the pressure for price increases. Thus, factors that are related to exchange-rate developments and independent of monetary policy are important in the formulation of this policy.
  Developments in the foreign-currency market in the first half of 1997 differed fundamentally from those in the second half (Figure 15). From the beginning of the year until the middle of June, the NIS/currency-basket exchange rate was at the lower limit of the band, with a large surplus supply of foreign currency. This obliged the Bank of Israel to intervene in the market and purchase foreign currency from the public to defend the crawling-band regime. The Bank of Israel's foreign reserves reached $18 billion by mid-1997. To prevent surplus liquidity in the money market and to meet the 1997 inflation target, the Bank of Israel absorbed the injection deriving from the foreign-currency market, mainly by increasing banks' time deposits in the Bank incurring a cost attributable to defending the exchange rate while achieving the inflation target6.
  An analysis of capital inflow (Table 1) shows that only part of it is sensitive to interest-rate differentials between Israel and abroad, while some of it is due to factors arising from investors' assessments that investment in Israel will prove profitable as its economy continues to grow in the medium and long term. The significant increase in foreign-currency credit taken by Israeli residents in the first half of the year (by means of domestic banks) is noteworthy. Bearing in mind the differentials in interest between Israel and abroad prevailing at that time, and the improvement in the balance-of-payments deficit, it seems that the private sector did not consider that taking foreign-currency credit bore a high risk because it assessed that the exchange rate would not change drastically in the short term. Apparently this view was backed by the assumption that there were no forces acting in the direction of real depreciation, and also by the Bank of Israel's commitment to achieving the inflation target, thus, maintaining a targetable rate of interest.
  In response to developments in the foreign-currency market during the first half of the year, the government decided on 18 June 1997 to progress further toward liberalization and changed parameters of the crawling band. The rate of change (slope) of the band's lower limit was reduced from 6 to 4 percent per year, and the upper limit was raised by about 15 percent, while its slope remained unchanged at 6 percent. The purpose of the change was to deepen the foreign-currency market and allow market forces to determine the exchange rate, with minimal intervention by the Bank of Israel, and to enable exchange-rate risks to be priced properly. Following this step, and as rates of return worldwide became more volatile a short while later, the private sector changed its assessment of the foreign-currency market, and the exchange rate moved away slightly from the lower limit (having risen by about 4 percent in the first few days following the change, then fallen again). Foreign-currency credit did not rise in the second half of 1997. This was consistent with the narrowing of interest differentials (mainly due to higher interest abroad), also indicating a rise in exchange-rate risk as perceived by the private sector. The rise in the risk premium on NIS/$ options is also of interest in this regard, showing the higher exchange-rate risk as assessed by investors. The extent of capital import by nonresidents, related to portfolio and direct foreign investment, remained high in the second half of the year.
  Local-currency depreciation in the summer months, along with other factors, was expressed in a temporary halt in the CPI downward trend evident since mid-1996. However, the effect of depreciation on inflation was not as unequivocal and immediate, as it was during time of a managed exchange rate and administrative devaluations. Uncertainty regarding future exchange-rate movements, with the rate free to move within broad limits according to market forces, and the menu costs of prices updating, weakened the link between short-term changes in the exchange rate and domestic prices. (Furthermore, prices are less affected by depreciation in an economy with a low level of real activity.)
  From 1996 to 1997, the NIS depreciated by 4.3 percent on average against the currency basket, and by 8.2 percent against the US$, while inflation abroad (in the industrialized countries) was about 2 percent.

Table 1
Capital Inflow into Israel, 1994-1997
  Total capital account
Capital flows of nonresidents
Capital flows of residents
of which: credit from authorized dealers
  Direct investment
Portfolio investment
1994 2218 334 558 1164 1496
1995 7889 1219 992 5684 5828
1996 4501 1268 1437 1809 2245
first half
5919 642 945 4570 4214
second half
1042 972 1162 -1038 386
($ million, cash basis)
Source: Controller of Foreign Exchange, Bank of Israel.


6 For details, see The Money and Capital Markets, Annual Survey, 1996, Bank of Israel, and the Bank of Israel, Annual Report, 1996.

(4) Fiscal Policy
  In 1997 there was a turnaround in the management of fiscal policy: the government met the deficit target after deviating from it in 1995 and 1996, and the budget deficit was 2.4 percent of GDP, as the rate of increase of public expenditure moderated. These steps reduced the balance-of-payment current-account deficit, and helped ease upward pressure on prices. In addition to its effect on inflation via cumulative demand, the reduction of the deficit enhances the credibility of macro policies in general, thus serving to lower inflation expectations thereby helping to achieve the inflation target.
  Since 1997, the deficit target in the Budget Deficit Reduction Law has been defined in terms of the total deficit (domestic and foreign), and the intention is to reduce it from 2.4 percent of GDP in 1997 to 1.5 percent in 2001.
  An analysis of the government's budgetary income and expenditure shows that expenditure increased more slowly than planned. The main reasons were that actual price rises were lower than those that had been used as the basis for the budget, and the fact that immigration fell. On the income side, there was a shortfall in tax revenues, mainly due to the decline in tax receipts from real estate transactions, in the wake of reduced construction activity, and from imports, as these contracted.
  Although the total deficit in terms of GDP was below that planned, the domestic deficit exceeded the target (Figure 16). The government's domestic deficit in 1997 was 2.9 percent of GDP, compared with a planned 2.3 percent (note that the Budget Deficit Reduction Law relates to the total and not the domestic deficit). As a result of the increased domestic deficit, NIS 2.3 billion of it was covered by surplus financing in the foreign-currency budget. The domestic deficit has a pronounced effect on domestic demand, whereas the total deficit is important in determining the government debt burden.
  The composition of budget deficit financing has implications for the implementation of monetary policy (Figure 17). The budget deficit can be financed by net borrowing domestically or abroad. There was a considerable increase to about NIS8 billion in the government's proceeds from privatization in 1997 (which were intended for debt servicing and not current expenditure) that enabled net domestic borrowing to be reduced. Together with the proceeds from privatization, net domestic and foreign borrowing exceeded the financing required to cover the government's total deficit.

(5) Real Developments7

(a) GDP and unemployment:
  The real conditions in the economy are of prime importance in determining monetary policy intended to attain the inflation target. Smaller excess demand makes it easier for the adopted monetary policy to achieve a given inflation target, therefore playing a significant role in the process of deciding which monetary policy to adopt.
  The growth rate slowed considerably in 1997. GDP increased by 2 percent compared with 7 percent and 4.5 percent in 1995 and 1996 respectively (Figure 18). The unemployment rate, which rose to 7.7 percent (Figure 19), reflected the moderate level of activity, together with the economy's shift from traditional to high-tech industries, combined with the difficulties associated with the adjustment of the labor force to this structural change. Higher unemployment, however, was not reflected by a slowdown in the real wage, which rose by 2.4 percent in 1997. This rise reflects a significant increase in the real business-sector wage, resulting inter alia from excess demand for labor in certain sectors (mainly in high-tech industries). Making it more flexible on one hand while reducing the incentives not to enter the labor force on the other, labor market reforms may make a major contribution to lowering unemployment. (Note that unemployment increased in the context of a large number of foreign workers, estimated at more than 130,000.)
  The slowdown in real activity resulted from long-term and short-term factors, on both the supply side and the demand side. Fiscal and monetary policies acted to reduce the balance-of-payments deficit and to achieve the inflation target. Also, on the demand side, the economy's adjustment to the fall in immigration served to lower demand, particularly in housing and investment. Political uncertainty and security incidents also eased demand, particularly for tourist services. On the supply side, the process of transformation transfer from traditional to high-tech industries has a temporary adverse effect on aggregate supply. The cumulative negative effect on the profitability of the traded goods sector, deriving from the real appreciation of the NIS against the currency basket, also contributed to the slower expansion of supply. Mainly harming traditional industries, the raising of the minimum wage, also had a significant negative effect on these industries' supply.
  The economic slowdown affects monetary-policy decisions on the interest rate needed to achieve the inflation target. It is taken into account by examining inflation expectations, by incorporating GDP in macro-econometric models, and in the judgement used to determine policy. The more moderate the level of real economic activity, the less contractionary the policy required to achieve inflation targets.

(b) The balance of payments:
  In 1997 there was a marked improvement in the balance-of-payment current-account deficit (Figure 20), which declined from $5.5 billion in 1996 to $3.6 billion in 1997, with an increase in exports and no change in imports. The improvement in the balance of payments reflects a reduction of the import surplus and an improvement in Israel's terms of trade. Reducing the balance-of-payments deficit has become the government's main objective in 1997, because its level in 1996 - more than 5 percent of GDP - threatened to harm Israel's international standing, as such a deficit cannot be maintained for long. This consideration became even more important in light of the financial crisis in Asia.
  The slower reduction of the import surplus in the second half of the year was also reflected in the development of the trade deficit. Following a significant improvement from the middle of 1996 - mainly due to a decline in goods imports - the deficit fell much more slowly in the second half of 1997, and is still high. Exports did not follow a uniform pattern in 1997 (Figure 21). Total exports (volume) rose by 13 percent, with a rapid expansion in the high-tech industries and a slowdown in the traditional ones. The change is due, at least partly, to the change composition of world demand for different types of goods and the greater flexibility of the traditional industries to changes in the relative price of their exports.

7 For more detailed and profound analysis see Bank of Israel Annual Report, 1997, March, 1998.

(6) External factors
  Israel's small, open economy is greatly affected by world developments. World prices impact both on real activity, via the profitability of exports and the cost of imports, and on domestic price changes, via traded goods prices and production factors. Dollar prices of imports were 5 percent lower in 1997 than in 1996 (Figure 22), while export prices fell by only 1.7 percent. Thus, Israel's terms of trade improved by 3.5 percent.
  In the second half of 1997, the financial crises in South-East Asian countries, and their adverse effect on real activity in many countries may well make a mark on domestic developments in Israel's economy. It is difficult to quantify these effects but the improved ability of those countries' exports to compete, their reduced income (which will lower their demand for imports) and the slowdown in the expansion of world trade may well make imports from them cheaper, reduce demand for Israel's exports, and bring growth down to a lower path than before.

4. The background and the policy required to achieve the 1998 inflation target

(1) Long-term inflation expectations
  Long-term inflation expectations serve as an indicator for the assessment of individuals' confidence in (fiscal and monetary) policy-makers' ability to achieve the targets in the next few years. Current expectations deviate slightly from the path which would lead to 4.5 percent inflation in the year 2001, suggesting that the public is still uncertain regarding the reduction of inflation.

(2) Conditions for the continued reduction of inflation
  In light of the government's decision in August 1997 to achieve over time, the price stability customary in industrialized countries and to continue reducing inflation, the framework of policy - both fiscal and monetary - consistent with these goals must be maintained.

  Fiscal policy: Meeting the deficit target set by the government is a sine qua non for progressing with disinflation while controlling the balance-of-payment deficit. An ongoing budget deficit, alongside a greater rise in the government's internal debt than in GDP, will end up being financed by a rise in the money supply, and eventually will lead to inflationary pressure. Moreover, the reduction of the deficit according to the path set must be achieved by cuts in government expenditure, with less public-sector intervention in economic activity and a lower tax burden. Care must be taken that increases in the prices used as a basis for the budget are not out of line with the inflation targets.

  Wage policy: The nominal rate of change in wages is one of the main elements which enable the rate of price increases to be retarded. Negotiations currently in progress over public-sector wage agreements for the next few years must lead to results which reflect the government's commitment to a declining inflation target. It is essential to address the issue of the determination of public-sector wages as these represent a significant part of government expenditure, and may also affect private-sector wages, although the mechanism linking the two has weakened in the last few years.

  Increasing competitiveness: Reducing government intervention in the economy and proceeding with privatization while ensuring competitiveness, themselves worthy long-term objectives8, will help reduce inflation by making the transmission mechanism of monetary policy more efficient. Infrastructure investment and retraining labor in accordance with structural changes in the economy, together with other labor-market reforms, are essential to enable monetary policy to achieve the inflation target while minimizing its short-term cost.

  Exchange-rate policy: Exchange-rate policy must be consistent with the processes of disinflation and the liberalization of capital flows. The Bank of Israel will allow market forces free expression within the crawling exchange-rate band.

8 For details, see An Economic Program for 1996-2000, Research Department, Bank of Israel, Summer 1996.

(3) Monetary policy and the development of inflation in the next few years
  In the light of the inflation environment in 1997, the economic situation, and the conditions outlined above, monetary policy makers must examine what the interest policy should be to enable inflation targets set by the government to be achieved over the next few years, and to ensure that the inflation environment continues its decline. In particular, the targets should not prevent faster progress toward price stability, if circumstances permit, without increasing monetary and fiscal restraint.
  The decision on the Bank of Israel's interest rate required to meet the inflation targets is based on two main instruments - the various indicators of economic development, and macro-econometric models9 which relate specifically to the transmission mechanism of monetary policy and to the whole complex of links between changes in interest and the inflation environment (see Appendix 2 for a description of the process of monetary-policy decision making). The models are very specific, however, regarding parameters as well as formulation so that decision making cannot be based on them exclusively. The process of monetary planning, therefore, combines conclusions drawn from the models with more judgmental analysis of many indicators.

9 For details, see E. Azulay and D. Elkayam, "A Model for Examining the Effect of Monetary Policy on Activity and Prices in Israel, 1988-96", Occassional Papers: 97.01, Monetary Department, Bank of Israel (forthcoming) (Hebrew).

Appendix 1

Macroeconomic targets set by the government in the last two years*

1. Inflation targets: (Decision No. 1127, dated 27.12.96)

It is decided that:

The government notes the decision of the Minister of Finance, reached after consultations with the Prime Minister and the Governor of the Bank of Israel, that the inflation target for 1997 is 7-10 percent, and that the target for 2001 will be the norm in OECD (the Organization for Economic Cooperation and Development) countries.
The target for 1998 will be determined by the middle of 1997. In the following years, the target will be set in a similar manner so that it will serve as the government's working premise in determining the following year's budget framework and target, as well as monetary policy.
It is in this context that all the main targets of economic policy on which the proposed 1997 budget focuses should be viewed:
i) reducing the current-account deficit;
ii) creating the conditions to enable continued stable economic growth;
iii) reducing the rate of inflation;
iv) absorbing immigrants.

2. The government's economic policy - monetary policy guidelines
(Decision No. 2456, dated 8.8.97)

It is decided that:
The government adopts the decision of the Minister of Finance, taken with the knowledge of the Prime Minister and after consultation with the Governor of the Bank of Israel, and sets the following targets for economic policy for 1998:

To move toward full realization of the economic growth potential currently estimated at an annual 5 percent, with the aim of achieving sustainable growth.
The inflation target for 1998 is 7-10 percent.
To continue gradually lowering the rate of inflation, with the intention of eventually achieving the price stability customary in industrialized countries.
To raise the level of employment in the business sector.

* Excerpts from the decisions.


Appendix 2

The Bank of Israel's monetary policy: the decision-making process

The Bank of Israel gears its main policy instrument - the short-term interest rate - toward achieving the inflation targets determined by the government. Decisions on interest-rate policy are based on a view whose main aspects are as follows: i) The Bank of Israel's interest rate (the rate of interest paid on banks' deposits with the central bank) has a delayed effect on inflation, via the ramifications of the direct and indirect transmission mechanism. ii) Inflation is also affected by other important factors, such as fiscal policy, expected developments in wages and employment, changes in the exchange rate, prices abroad, etc., all of which are taken into consideration when decisions are made. iii) Setting the rate of interest, which in the Bank of Israel's view will help achieve the inflation target determined by the government, is based on estimates derived from econometric models and experience, and several estimates of future price developments.

The decision-making process is as follows:

A. Annual program
Once a year, usually towards the end of the year, the Governor of the Bank, along with senior staff and monetary specialists, engage in an annual monetary programming session. At that time the main aspects of planned fiscal policy are known and there are estimates regarding the development of factors exogenous to the economy - the relevant world prices, the expected level of trade, etc. Also, at that time, preliminary estimates of the expected level of economic activity in the following year are available. All these, together with data on inflation expectations derived from the capital market and other sources, serve to form an assessment of nominal and real interest rates (the latter is the Bank of Israel interest rate minus expected inflation) which will enable the inflation target set by the government to be achieved.

B. Monthly program
Once a month, the Governor of the Bank and the Bank's professional staff hold a discussion based on material prepared by three of the Bank's departments, the Monetary, Research, and Foreign Currency departments.
The discussion is divided into two parts: In the first, reviews prepared by economists in the three departments are presented. In the second, a more restricted forum, the members of the Monetary Forum take part. These are the Governor, the directors of those departments, and several economists.
After the discussion, a decision is made as to whether the Bank's interest rate should be changed, and if so in which direction. The discussion covers: a) Inflationary (deflationary) pressures already evident in the economy, these will not be greatly affected by current changes in monetary policy; b) Various factors which have a bearing on inflation and which monetary policy can still affect.
The main but not sole indicators on which policy decisions are based are: a) The inflation environment, including the development of inflation during the previous twelve months (or any appropriate sub-period), and inflation expectations for the year, derived from the capital market. b) The nominal rate of growth of the money supply compared with that required based on both the inflation target and estimates of the level of real activity. c) Fiscal policy - its actual development compared with its goals. d) Actual and expected developments in the balance of payments and the exchange rate. e) Estimates of real activity on the demand and supply sides. Wage developments are also taken into account, as are unemployment and other factors likely to affect prices.
In the second part of the discussion, each participant gives his or her assessment and recommendations based on the material presented.

C. Weekly forum
The restricted forum in which the monthly decisions are taken also meets once a week, to continually monitor developments in liquidity, inflation expectations, the money supply, the exchange rate, etc.

D. Daily forum
The Monetary Department forum meets daily to decide on the extent of sources to be absorbed from (or injected into) the banking system, to ensure that the Bank of Israel's interest rate remains in the environment set for it.