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Governor's letter
The Inflation Report for the second half of 2002 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 monetary policy. Transparency in the management of macroeconomic policy (fiscal and monetary) is an important component of the certainty needed by foreign and Israeli investors.
The Consumer Price Index (CPI) rose by 0.2 percent in the second half of 2002, constituting a 6.5 percent increase for the year as a whole. The annual increase represents a marked deviation from the inflation target for the year, which was 2–3 percent, and an acceleration relative to the 0.9 percent annual average of the last three years. Since the increase in the second half of the year is below the target, and inflation assessments for 2003 are within the target range of 1–3 percent, it is very important to analyze the notable difference in the rate of price rises in the first and second halves of the year.
The acceleration of the rate of price increases in the first half of the year stemmed largely from the accelerated local-currency depreciation of 15.5 percent against the dollar and 17.8 percent against the euro. The depreciation began immediately after the announcement by the government and the Bank of Israel at the end of 2001 of an economic package to stimulate employment and growth. In accordance with the package, the Bank of Israel lowered its key interest rate by 2 percentage points, from 5.8 to 3.8 percent, and the government undertook to reduce its deficit and cancel costly legislation by individual Knesset Members. The object was to change the policy mix, and replace expansionary fiscal policy and restrictive monetary policy with fiscal discipline and monetary expansion. The policy shift was supposed to lead to a reduction in the real interest rate for all maturities, thereby bolstering investment and growth.
By mid-February the concurrent asset portfolio adjustment and depreciation appeared to have come to an end, but when it became clear in March and April that the government was not meeting its commitment to reduce the deficit, which was in fact expanding rapidly, accelerated depreciation and price rises ensued. This was exacerbated by the deterioration in the security situation, as well as the attempt to restrict the central bank’s independence by proposing legislation which went counter to accepted international norms. Inflation expectations, which had varied within the target range in 2002 Q1, exceeded the upper limit in April and May, and yields on both indexed and unindexed government bonds for all terms rose steeply. All this served to imperil financial stability.
The main reason for the cessation of inflation and the rapid depreciation in the middle of the year was the Bank of Israel’s interest-rate hike in June, and this constituted a cumulative 4.5 percentage points, bringing interest up to 9.1 percent at the beginning of July. Fiscal policy also contributed to restoring stability, by raising taxes, including those on labor, and making budget cuts, especially in transfer payments, while again raising the budget deficit target, from 3 to 3.9 percent of GDP, compared with the original target of 1.5 percent of GDP.
Despite the low inflation rate and the local-currency depreciation in the second half of the year, there is still considerable uncertainty, as expressed in the price of NIS/dollar options, for example. Note that some of the basic causes of economic instability have not yet been removed. Thus, fiscal policy continues to create large budgetary deficits, causing the public debt/GDP ratio to soar, the security situation is still problematic, and real economic activity remains weak. The absence of change in these spheres places a very heavy burden on monetary policy when it comes to maintaining stability.
Note, too, the high variability of the monthly rates of change of the CPI, which did not decline significantly in the second half of the year, despite its slower cumulative rate of increase. This development indicates that the process of returning to price stability has not yet entrenched itself.
The marked difference in developments in the two halves of the year indicates that there are several lessons to be learned regarding the management of macroeconomic policy:
- Price and financial stability depend to a great extent on public confidence in the determination of policymakers to adhere to the inflation and budget deficit reduction targets. The acceleration of prices, local-currency depreciation, and rise in yields on government bonds that came in the wake of the policy shift at the end of 2001 were all above their predicted levels—as derived from the securities markets, as foreseen by private forecasters, and as predicted by the Bank of Israel’s econometric models. This attests to the public’s skepticism regarding the possibility of making rapid changes in the policy mix combining budgetary discipline, involving a reduction in long-term interest, with monetary policy that concurrently reduces short-term interest rates.
- The fact that the recession persisted throughout the year, despite the monetary expansion at the beginning of it, attests to the inability of monetary policy to stimulate real economic activity, even in the short run, when other powerful factors exert decelerating pressure, and there are apprehensions that economic and financial stability will not endure.
- The rehabilitation of credibility and adherence to the maintenance of stability oblige a return to a path involving the gradual reduction of the interest rate, which might serve to accelerate inflation in the region of the lower limit of the target for a while. As long as there is no significant reduction of the deficit and the yields on government bonds, the over-rapid reduction of the Bank of Israel’s key interest rate could once more undermine stability and endanger real economic activity and the financial system.
- The eruption of inflation in the first half of the year, despite the recession, points to the limited ability of firms to absorb marked increases in production costs, which would have been required in view of the low level of demand.
- An important precondition for the success of monetary policy in checking the acceleration of inflation is a return to fiscal discipline, as the ability of the interest rate to check this acceleration over time is inevitably limited.
The main task for the economy in 2003, after two years of economic slowdown, and a decline in exports, investment, and living standards, is to stop the process of contraction and restore growth. The new government must implement a policy that focuses on reviving investment, increasing employment, maintaining stability, and reducing poverty. The Bank of Israel will support the government’s efforts in this direction.
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 Control Departments) within which monetary policy decisions are taken.
David Klein
Governor
Summary
- In the second half of 2002 (the period reviewed), the Consumer Price Index (CPI) rose by a moderate 0.2 percent, having risen steeply in the first half of the year. The rise in the index since the beginning of the year was 6.5 percent, significantly higher than the target of 2–3 percent.
- The driving force behind the increase in prices in the first half-year was the marked rise in the exchange rate, the result of an imbalance in the implementation of the economic program agreed upon at the end of 2001. According to the program the macroeconomic mix should have changed, with fiscal restraint replacing monetary restraint, which should have led to lower interest rates for all maturities to encourage employment and growth. Accordingly, the Bank of Israel slashed the interest rate by an exceptional 2 percentage points; the government, however, did not fulfill its undertaking to cut the budget deficit to 3 percent of GDP. These developments, together with a further deterioration in the security situation, the continued worldwide economic standstill and the worsening recession resulted in disquiet in the financial markets to the extent that their stability was brought into question.
- The intensification of the slowdown in economic activity encompassed most of the principal industries, and was reflected in reduced per capita GDP for the second year in succession and further slack in the labor market.
- The budget deficit totaled 4.0 percent of GDP, in accordance with the latest target set in June 2002, but far in excess of the original target of 1.5 percent of GDP. The target was raised three times in the course of 2002, and the target of 1 percent of GDP was pushed back to 2007. The significant deviation of the budget deficit contributed to the rise in yields in the financial markets during the year.
- To re-establish stability in the financial markets and prevent a financial crisis, steep hikes in the interest rate were necessary (there were three increases in one month, totaling 4.5 percentage points). These took place towards the end of the first half of the year, and in conjunction with the ending of the acceleration in fiscal expansion led to a return to stability and to the strengthening of the NIS. As a result, price rises moderated considerably in the second half of the year, and the rate of price increases was even lower than that required to meet the long-term inflation target.
- The trend towards stabilization of the financial markets in the second half of the year was not unbroken: in September uncertainty reappeared, in the light of concern that Israel’s credit rating was about to be lowered. At that time the NIS started depreciating again, while inflation expectations and yields on government bonds rose. The rise in short-term expectations was below that in the first half of the year, and the depreciation lasted only a short period. On the other hand, the rise in yields and in long-term inflation expectations was steeper, and persisted for longer, even after the exchange rate had stabilized.
- In October and November the NIS started appreciating again; in November short-term inflation expectations derived from the capital market declined, and in December they came within the target range. Yields on government bonds also fell, particularly on unindexed bonds, but still remained higher than in July and August. Long-term inflation expectations also stayed high, above the upper limit of the target range, despite their reduction in November and December.
The upward deviation from the limits of the target of expected short-term and long-term inflation derived from the capital market for a large part of the period reviewed, and the relatively high level of yields, and other indicators from the financial markets all made it clear that stability was not yet firmly established, and made it necessary to keep the monetary interest at its end-June level throughout the period reviewed. Relative stability was achieved at a relatively high real rate of interest considering the economic recession, due to the great uncertainty regarding future fiscal policy and in the light of other elements of uncertainty, headed by the security situation and the persistent recession, which reduce the economy’s financial soundness.
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