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Inflation Report 2003, July-December
Governor's letter
Jerusalem, January 28, 2004
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 Klein
Governor
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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