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Governor's letter
The Inflation Report for the first half of 20021 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.
In August 2000 the government decided on the path of the inflation targets for the next few years, setting the target for 2002 within a range of 2-3 percent and at the conclusion of the process, in 2003 and subsequently, at 1-3 percent annually, defined as price stability.
In the first half of 2002 the CPI rose by 6.3 percent, and for the year as a whole it is likely to deviate by up to 4 percent from the upper limit of the inflation target range.
In view of the deepening recession, the government decided towards the end of 2001 to revise the growth forecast underlying the budget, reducing it significantly (relative to the original 2002 budget proposal), while setting a deficit target for 2002 of 3 percent of GDP and a return to a declining deficit path with a target of up to one percent of GDP in 2005. In this context, the following package of policy measures was agreed upon: the Bank of Israel would cut its key interest rate by 2 percentage points and some structural measures would be introduced in the money and foreign-currency markets in order to accord the Bank of Israel greater effectiveness in the use of monetary instruments, further liberalize the foreign-currency market towards the completion of the process at the end of the year, and serve to make the exchange-rate regime more flexible. The assessment was that given these conditions long-term interest would decline and it would be possible to maintain price stability with a relatively low real interest rate while supporting the emergence of the real local-currency depreciation that would foster the rapid recovery of exports once world demand revived.
The change in the policy mix agreed upon at the end of 2001 acted as expected from the end of December until February to change the composition of the public’s asset portfolio alongside rapid local-currency depreciation, expressed-also as expected-in relatively high price increases. It was anticipated that these would stop once the process of asset portfolio adjustment, in response to the one-off change in yield differentials, was completed. At the end of February and the beginning of March, however, it transpired that fiscal policy had not been adjusted so as to restore the deficit to the agreed path, private legislation was not revoked and, in addition, at the beginning of March an amendment to the Bank of Israel Law was proposed which would impair its independence and its ability to adhere to the objective of maintaining price stability. Against the backdrop of the exacerbation of the security situation, these developments towards the end of March led to the renewal of rapid local-currency depreciation, a rapid rise in actual and expected inflation, and to indications that financial stability was being undermined, among them a sharp rise in government bond yields. In this context, the Bank of Israel raised its key interest rate by a cumulative 5.3 percent over the period as a whole, and by 4.5 percent in June, in three stages. After these interest-rate hikes, and in view of the approval in May of a package of measures intended to check the increase in the budget deficit, a trend of local-currency appreciation and the return of the expected inflation rate to the region of price stability emerged.
The primary policy target for the coming years is to restore the economy to a path of sustainable growth, enabling employment to rise while maintaining financial and price stability and reducing unemployment and poverty. The macroeconomic policy mix that is consistent with these objectives involves replacing monetary expansion by credible fiscal restraint. A mix of this kind will facilitate the maintenance of price stability with a relatively low real short-term interest rate and the reduction of long-term real interest while supporting real depreciation. These measures will serve to increase investment and exports, and hence growth and employment.
In order to sustain a policy mix of this kind, fiscal policy must ensure adherence to the deficit target of 3 percent of GDP set by the government for 2003, as well as to its declining path, to reach one percent by 2007. On the basis of current assessments of the 2003 growth rate, it is reasonable to assume that attaining the deficit target will require considerable spending cuts. It is particularly important for the budgetary adjustment to be implemented on the (current) expenditure side, and not to increase the tax burden, as was the case in 2002, as any such increase will signal continued deviation from the declining deficit path and hamper the restoration of GDP growth. In order to support the return to a growth path, it is necessary to increase the share of infrastructure investment in the budget; this will contribute to growth by raising business-sector productivity. To make sure that the deficit target set is adhered to, along with the lower tax burden and expenditure levels that are consistent with it, the implementation of the budget will have to be monitored by means of periodic reports to the government and the public.
The rise in unemployment and the low labor-force participation rates require labor-market reforms. These should include the rapid reduction in the number of foreign workers, especially the illegal ones, making vocational training and retraining more efficient, adjusting the rules governing the minimum wage, and reducing the negative incentive to work implicit in transfer payments. In addition, the ongoing decline in productivity calls for structural reforms as well as increased efficiency and competitiveness in the principal industries.
An amendment to the Bank of Israel Law has recently been brought before the Knesset. If it is passed it will hamper the central bank’s independence and ability to attain its objective of maintaining price stability. If and when the legislative process goes forward, it is important for the changes to adhere to the following principles, which are accepted in most advanced economies:
- The central bank’s policy objective should be to maintain price stability. Subject to this, the bank can also support employment and growth objectives, in accordance with the government’s economic policy.
- The central bank should have complete independence in choosing and deploying the necessary instruments for maintaining price stability; it should also have administrative independence.
- The government should not be involved in the foreign-currency market.
- The decision as to the short-term interest rate should be made in the framework of a Monetary Policy Council, headed by the Governor, whose members should be experts who are not tainted by conflicts of interest. The members should be put forward by an outside committee, selected by a transparent process, and approved by the government.
- The central bank should explain its policy in a detailed way in the framework of a periodic report, to be submitted to the government and the public.
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 heads of the Monetary, Research, Foreign Currency, and Foreign Exchange Control Departments) within which monetary policy decisions are taken.
David Klein
Governor
Summary
- After low inflation rates of 1.3, 0, and 1.4 percent in 1999, 2000, and 2001 respectively, the Consumer Price Index (CPI) rose by 6.3 percent in the first half of 2002 (the period reviewed)-above the upper limit of the inflation target range for 2002 (3 percent).
- The reason for the increase in prices was the marked local-currency depreciation. which has amounted to 14.5 percent since the announcement in December 2001 of a package of economic measures, and up to the third week of June.
- Inflation expectations for various terms-expressing the public’s assessments of the inflationary forces -soared in the period reviewed. Expectations for one and two years ahead were over 4 and 5 percent respectively in June, i.e., above the upper limit of the inflation targets for the next few years (3 percent).
- The rise in inflation and its causes contributed to the growing instability of the financial markets in general, and the foreign-currency market in particular. The instability was expressed in the marked increase in exchange-rate volatility, soaring yields on government bonds (the yield on long-term Shahar bonds rose from 6.5 percent at auction prior to the interest-rate cut of December 2001 to just under 12 percent at the end of June), a shift towards liquidity in the composition of the public’s asset portfolio, and a rise in the yield on indexed bonds. Instability was also evident in the yield on Treasury bills, which rose from 5.5 percent at the beginning of the year to 9 percent in June.
- The change in the policy mix announced in December 2001-expansionary monetary policy (a 2 percentage-point interest-rate cut) and tight fiscal policy (a deficit of 3 percent of GDP and return to a declining deficit path for the coming years)-led to a change in the composition of the public’s asset portfolio from that point on until February 2002, as well as to the adjustment of prices and the exchange rate to the new macroeconomic situation. In this period there was marked local-currency appreciation (11.5 percent), inflation expectations rose from below the lower limit of the target range for 2002 to the region of the upper limit (3 percent), and long-term yields dipped slightly. Following the 0.6 percentage-points increase in the interest rate by the Bank of Israel in March, the exchange rate stabilized and inflation expectations reverted to the target range.
- From the end of February the public began to realize that the budget deficit target for 2002 and subsequent years, as announced in December, would not be attained, and in view of the forecast of low GDP growth in the next few years the general assessment was that there would be an increase in the public debt. Furthermore, the failure to revoke private legislation (the Negev Law, etc.), as agreed, the proposal to amend the Bank of Israel Law proposed at the beginning of March and including sections which would impair the central bank’s independence in administering monetary policy, the deterioration in the security situation in March, and the appointment of the Rabinowitch Committee on tax reform at the end of February, creating uncertainty regarding relative yields on the public’s assets and the extent of the resources that would be required from the budget in the next few years to finance the reform-all led to sharp and continuing increases in the CPI, inflation expectations for 12 months (to 5.8 percent in June) and longer, further cumulative local-currency depreciation of over 3 percent until the 2 percentage-point interest-rate hike in June, and soaring long-term bond yields in the market (over 10 percent in June) between April and June.
- These developments in 2002:II, and the local-currency depreciation in particular, indicated the erosion of public confidence in the commitment of macroeconomic policy to maintaining price stability (as expressed in the fact that inflation expectations rose above the target range), as well as the erosion of foreign investors’ confidence in Israel’s economic stability. This could be seen from the reduction in capital inflow-which is motivated by long-term considerations, and in recent years has had a stabilizing influence-in view of the crisis in the high-tech industry (since 2001).
- Inflation accelerated, despite the increase in unemployment and the economic slowdown, aggravated by the security situation. Business-sector product declined, and only the sharp rise in public defense consumption prevented GDP from falling in the period reviewed. The slowing of Israel’s GDP growth rate served to widen the output gap-the difference between actual and potential GDP (at full employment). Thus, the labor market remained slack and the real business-sector wage declined. All these factors served to moderate the increase in prices.
- The economic slump acted to weaken the robustness of some firms, as expressed in a decline in their profitability, and hence in their ability to repay debts. This deterioration operated to reduce the extent of financial intermediation (as expressed in the moderation of the rate at which bank credit expanded), and could hamper the ability of monetary policy to attain its aims.
- In the wake of the fact that inflation expectations exceeded the upper limit of the target range of price stability (1-3 percent), the Bank of Israel introduced a series of interest-rate hikes at the end of the period reviewed,, some of them rather large, accumulating to a 5.3 percentage-point increase in the period reviewed, so that at the end of it the interest rate was 9.1 percent. Concurrently, the government formulated a package of measures, which it succeeded in getting through the Knesset. This was aimed at checking fiscal deterioration (including preventing the introduction of private legislation) and returning to a declining deficit path in 2003, in order to restore stability to markets and prices. Nevertheless, this package of measures is not sufficient to restore the economy to a path of sustainable growth with increased employment-the precondition for improving welfare.
- At the end of the period reviewed there appeared to be a reversal of the exchange-rate trend, by virtue of the fiscal and monetary policymakers’ determination to restore stability to prices and the financial markets. There was marked 5.5 percent local-currency appreciation from the end of June until mid-July, inflation expectations for 12 months ahead fell by 2 percentage points, and in mid-July were within the inflation target range. It is still too early to tell whether Israel has returned to the price stability it enjoyed in the last few years, however.
1This document also serves as a Report on the Expansion of the Money Supply, in accordance with section 35 of the Bank of Israel Law, 5714-1954, following the 22 percent rise in the money supply from June 2001 to June 2002. The development of the monetary aggregates is described on p. of this report. Similarly, in accordance with cabinet decision no. 4167, this report notes that the inflation rate for 2002 is expected to be more than 2 percentage points above the upper limit of the inflation target range, and gives the reasons for this.
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