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Governor's letter
The Inflation Report for the second half of 2003 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 an aid to households and firms, both resident and nonresident, in planning their economic activities.
In August 2000 the government decided on 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 a target defined by a calendar year but rather a continuous and constant target, and at any point in time the policy is aimed at attaining it within the next twelve months. This allows for temporary, short-term deviations in either direction in order to avoid wide fluctuations in the interest rate. Temporary deviations may occur because prices are affected in the short term by factors which cannot be rapidly offset by interest-rate policy, such as additional information regarding the budget deficit, short-term movements in the foreign-exchange market and shocks in global markets.
The CPI (Consumer Price Index) declined by 1.4 percent in the second half of 2003, and by 1.9 percent in the year as a whole, below the long-term target consistent with price stability. The decline was most pronounced in 2003:II and 2003:III, and was related to the significant appreciation of the NIS against the dollar from February to July as well as to the low level of real economic activity. This affected prices via the dampening of demand and cuts in wages in various sectors. Although, as stated, the CPI deviated from the inflation target, inflation expectations for one year forward and beyond—those derived from the capital market as well as those of forecasters—remained within the target range throughout the period reviewed (July–December 2003).
In contrast to the declines in prices of goods and services, in the exchange rate, in housing prices and in wages, prices of domestic financial assets rose considerably, mainly share prices, but also bond prices, and in particular prices of unindexed bonds.
These price developments stemmed from several basic factors, some of them related to the global and domestic geopolitical situation and some to economic policy. The formation of a relatively broad-based government that quickly adopted a wide-ranging economic plan, the rapid conclusion of the war in Iraq, and the decision by the US government to provide guarantees for Israel’s new loans all served to significantly lower Israel’s country risk, the degree of uncertainty in Israel’s foreign currency market, and the government’s need for domestic borrowing. The strengthening of the NIS against the dollar was also a consequence of the latter’s weakness on world markets. All the above, together with growing worldwide willingness to invest in emerging markets, led to some increase in capital inflow to Israel.
The government formed at the beginning of 2003 succeeded in instilling confidence in the public and the markets regarding its intention to restore fiscal discipline, as reflected by a decline in the deficit and debt relative to GDP. This was manifested by its budgetary decisions and several proposed structural reforms, despite the rise in the deficit from 2002 to 2003, its significant deviation from the target, and a renewed rise in the debt/GDP ratio. The feeling that the government did indeed intend to re-establish fiscal discipline was reflected inter alia by the decline in yields on the different types of long bonds
Against this background, the monetary restraint that was imposed in the second half of 2002—with the intention of halting the surge in inflation at the beginning of that year and removing the threat of a financial crisis then hanging over the economy—was eased, and the Bank of Israel gradually reduced its key interest rate from 9.1 percent at the end of 2002 to 4.8 percent at the end of 2003. Although the latter interest rate is still higher than that prevailing in most advanced economies, interest-rate spreads, particularly between different domestic rates, are low. The policy of gradually reducing the interest rate was necessary in the light of the erosion of confidence in macroeconomic policy in 2002, and it enabled the Bank of Israel to assess the markets’ reaction to the steps taken. Note, in this context, that in the decade since the introduction of the inflation-target regime inflation has overshot the target range four times, and in every case a factor unrelated to monetary policy was involved, e.g., the start of talks with the Palestinians following the Oslo Agreement, the global financial crisis, and fiscal expansion instead of the fiscal restraint that should have accompanied monetary expansion. After each of these inflationary surges the Bank of Israel had to restrain inflation and regain the public’s confidence in its determination to adhere to the policy of achieving price and financial stability, by raising its key interest rate.
Throughout the decade Israel’s governments have not given sufficient support to the policy of obtaining price and financial stability. This was expressed, inter alia, by their reluctance to follow many of their counterparts abroad in the 1990s by adopting a modern central bank law that would clearly set price stability as the main target of monetary policy, thereby contributing to economic growth. This should go hand in hand with the appropriate institutional arrangements, primarily instrument independence and a professional Monetary Council untainted by conflicts of interest.
The current objective of monetary policy is to bolster economic growth while maintaining price and financial stability. The Bank of Israel assesses that despite the sharp rise in prices of domestic financial assets and the revival indicated in real activity, it may be possible to continue lowering the interest rate, as long as price stability is maintained and the financial markets remain calm. The latter now depends more and more on confidence in the government’s ability to steer the economy back to a path of growth while maintaining stability. The government’s economic program laid the foundations for achieving this objective, and is now entering the phase of being tested by actual implementation, at the same time as certain required missing components are being added. These will enable the government to carry out its fundamental decisions: to massively increase infrastructure investment while implementing the structural changes required to make the economy more competitive; to close the gap between the rate of employment in Israel and the norm in other countries while carrying out reforms in the labor market; and to adopt a policy aimed at reducing poverty.
Concurrently, a detailed work plan should be formulated and presented to the government and the public enabling the government to carry out its critical decision to restrict the increase in its expenditure between 2005 and 2010 to one percent a year. The opportunities offered by the US government loan guarantees are limited in time and quantity. When the window of opportunity closes, in another two years, the share of government expenditure in GDP must be on a path that enables the easing of the tax burden and debt to continue. This is the core of the policy of continuous growth by means of the business sector.
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
The Consumer Price Index (CPI) declined by 1.4 percent in the second half of 2003, and by 1.9 percent from the beginning of the year, below the lower limit of the inflation target (1–3 percent).
Despite price reductions during the year, one-year inflation expectations derived from the capital market were within the target inflation range until November, and throughout the year the assessments of private forecasters for one year were within the target range and for 2004 were close to the middle of the range. Longer range forecasts were within the target range or above it each month.
The fall in the CPI was most pronounced in 2003:II and 2003:III, and was related to the significant local-currency appreciation against the dollar from February to July and the low level of real economic activity. Although some recovery in real activity was evident in 2003, mainly in the second half of the year, with GDP rising by 1.2 percent after two years of contraction, the output gap remained negative and high, exerting pressure to moderate the rate of price increases or even to reduce prices.
The local-currency appreciation resulted from the marked reduction of uncertainty and Israel’s country-risk premium as well as the wide interest-rate differentials between the NIS and the dollar, and the weakening of the dollar worldwide. Uncertainty started to abate towards the end of 2003:I following the rapid conclusion of the war in Iraq, the increased credibility of fiscal policy, the approval of the loan guarantees by the US government, and the renewal (albeit short-lived) of the peace process (the hudna, or ceasefire).
Shortly after its formation at the beginning of 2003, the new government adopted a program of cuts in the budget planned at the end of 2002, and structural reforms of great importance for the long-term streamlining of the economy. These decisions increased the public’s confidence in the government’s intention to restore fiscal discipline in the next few years to be reflected by a declining deficit and debt relative to GDP, even though the budget deficit was expected to considerably exceed its target in 2003. Although fiscal restraint contributed to the low level of demand during the year, it was necessary for maintaining financial stability in view of the experience of 2002.
Price reductions in the months when the NIS appreciated were due largely to the considerable weight of the housing component in the CPI and the close relation between housing prices and changes in the exchange rate. In July the trend reversed, and the NIS depreciated moderately, since when price reductions have flattened out and occurred in nearly all the components of the index.
Monetary policy also played a role in the moderation of price changes, via its effect on demand and inflation expectations, and as the result of the relatively high interest-rate differentials between the NIS and other currencies throughout the first half of the year. The continuous cuts in the interest rate could only start in the second quarter of 2003, when it became clear that the reduction in uncertainty was not a passing phase; however, in the light of the circumstances that necessitated the hike in the interest rate in the middle of 2002, it was important to start with modest cuts in the rate and see whether the positive trends persisted.
As the positive trends in the financial markets continued, and against the background of the very moderate rate of price changes from the second quarter, the Bank of Israel stepped up the pace of cuts of the interest rate. Since June the rate has been reduced by 0.4–0.5 percentage points each month, giving a cumulative reduction of 2.8 percentage points in the second half of 2003, and a total of 3.9 percentage points since the beginning of the year.
The Bank of Israel has avoided increasing the pace of reductions in the interest rate due to concern that lowering the rate more rapidly would result in too fast a narrowing of the interest rate differentials, and would thus encourage rapid and undesirable adjustment of the asset portfolio, which could well undermine financial stability. Moreover, there was concern that faster reductions in the interest rate would again raise doubts in the public’s mind regarding the Bank’s determination to adhere to the policy of long-term price stability.
The NIS/$ exchange rate during the year was affected largely by the activity of nonresidents in short-term financial instruments vis-à-vis the NIS. This activity was in turn affected by both global trends and the reduction in Israel’s country risk, together with the narrowing of the interest-rate differentials between the NIS and other currencies.
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