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The Consumer Price Index (CPI) went up by a cumulative 0.5 percent in the first half of 2005, and by 0.3 percent in the last twelve months––a rate below the lower limit of the inflation target range of 1–3 percent. This is a continuation of the low-inflation environment that prevailed in the last two years.

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The Bank of Israel continued to lower the interest rate at the beginning of the period reviewed. This took place against the background of a moderate level of price increases, inflation expectations that were within the inflation target range, a reduction in bond yields, and stable domestic currency markets. Thus the interest rate was cut by 0.2 of a percentage point in each of the months December 2004, and January and February 2005, to reach the low level of 3.5 percent.

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In the second quarter the capital and money markets remained stable, while the short-term-interest differentials continued to contract. It seemed that inflation in the next twelve months was expected to be close to the midpoint of the price stability target range. The Bank of Israel therefore kept the interest rate for the months March to June unchanged.

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The NIS/dollar exchange rate is known to have a considerable effect on price changes in Israel, both via its effect on housing prices (most of which are quoted in dollars), and via its effect on imported goods. For most of the first half-year the NIS was traded with no clear trend and with low volatility, and constituted a major reason for the small rise in the CPI. In June the NIS depreciated sharply against the dollar, and the effect of this on prices has not yet been realized in full.

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Global factors, headed by the strengthening of the dollar world wide, served for most of the period reviewed to weaken the NIS (against the dollar), while domestic developments had only a minor effect. In contrast the rapid depreciation that occurred in June was due almost entirely to domestic factors.

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The differential between the short-term interest rates of the US Federal Reserve and the Bank of Israel stood at only 0.25 percentage points at the end of the period reviewed. The contraction of the differential to this unprecedented level without causing shocks in the Forex market could occur in the light of the decline in Israel's country risk and the rise in the US dollar currency risk.

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The continued growth of economic activity in the first half of the year, albeit at a slower rate than in the equivalent period in 2004, and the sharp fall in the unemployment rate in the first quarter of 2005 did not cause upward pressure on prices, as a result of spare production capacity in the economy.

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Two other stabilizing influences affected price rises and monetary policy in the period reviewed: (a) fiscal discipline, which the public afforded credibility despite the delay in approving the budget, and which was reflected by the reduction of future yields on long bonds; and (b) the relative calm in the security situation in Israel at this time.

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The rate of inflation in the last twelve months, which was below the target range, as stated above, was also lower than the level forecast a year earlier. At the end of the first half of 2004 inflation expectations––derived from the capital market, private forecasters, responses of companies participating in the Bank of Israel's Company Survey, and Bank of Israel models––were within the price-stability target range, with a rise expected in the Bank's interest rate. The difference between actual inflation and that which had been predicted derived mainly from the assessments a year earlier that the contraction of the interest–rate differential between Israel and abroad and the equalization of tax rates on domestic and foreign assets would lead to NIS depreciation against the dollar, and hence to price increases. The depreciation did not occur, as mentioned above, despite the response of Israelis to the contraction of the interest-rate differential, mainly due to large unanticipated inflows of capital from nonresidents into the economy.

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Current assessments and expectations––derived from the capital market, private forecasters, companies participating in the Company Survey, and Bank of Israel models––are that prices will rise somewhat faster during the year to a rate close to the midpoint of the target range (2 percent). Some of these assessments are based on the assumption that the Bank of Israel interest rate will be raised a little towards the end of the year. Simulations carried out in the Bank of Israel using economic models show that if the NIS/dollar exchange rate settles at the level it reached at the end of June, and the Bank of Israel interest rate also remains at its present level, the rate of price increases in 2005 will be close to the upper limit of the target inflation range, and in the next twelve months is even likely to exceed it and make it necessary to raise the interest rate thereafter. Under these assumptions, according to the models, a higher rate of inflation than that prevailing hitherto will be caused by continued growth, the reduction of unemployment, the low level of real interest, and the depreciation that has already taken place.