Previous Inflation Reports
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Inflation Report 2004, January - June
Governor's letter
Jerusalem, July 2004
The Inflation Report for the first half of
2004 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 a means of increasing economic confidence of
Israeli and foreign companies and individuals and contributes to the proper
functioning of the markets and the economy as a whole.
The CPI (Consumer Price Index) rose by 1.4
percent in the first half of 2004, and in the twelve months to June 2004 it was
unchanged. The rise in the CPI in 2004 and in the coming twelve months is
expected to be within the price-stability target range of 1–3 percent
determined by the government in August 2000. A fixed, continuous target, not
per calendar year as was the case previously, enables policy to act at all
times to achieve the target for the next twelve months, while allowing for
temporary deviations in either direction in order to minimize fluctuations in
the interest rate.
In the half year under review the rate of
price increases rose towards the middle of the target range, against the
backdrop of recovery in real activity that started in the second half of 2003
after two years of recession, and depreciation of the NIS against the dollar
following its marked appreciation in 2003. Together with the rise in prices,
inflation expectations also went up towards the middle of the target range.
During this period the Bank of Israel acted
to attain the target of price stability, reducing the interest to as low a
level as possible without adversely affecting stability, while constantly
reviewing the indicators that guide its policy. Accordingly, the Bank’s
interest rate was lowered by a cumulative 1.1 percentage points from the
beginning of the year to April, when it reached 4.1 percent, and was kept at
that level thereafter.
Economic developments in Israel were led to a
large degree by the recovery of global demand, particularly for output of the
high-tech industries, which helped to boost exports. The improvement in the
economic environment was also supported by the relative quiet on the security
front in the period, which resulted in a rise in investment, private
consumption and imports. These were helped by the improved mix in macroeconomic
policy, i.e., tighter fiscal discipline combined with monetary expansion,
reflected by relatively low long-term and short-term real interest rates.
The cuts in government expenditure in line
with the target set, together with a significant increase in tax revenues
resulting from the recovery in economic activity, are expected to enable the
government to meet the deficit target for 2004, which was raised to 4 percent
of GDP. The government decision to reduce tax rates following the increase in
tax receipts while still meeting the deficit target, instead of reverting to
the original deficit target of 3 percent of GDP, will be reflected in the
continued rise in the public debt/GDP ratio in 2004.
Government policy plays a major part in
shaping the economic environment. Fiscal discipline considered by the public to
be credible is also essential for the management of monetary policy. The
public’s assessment that the government is staying within the budget and
deficit framework is likely to be expressed in lower long-term interest rates,
in lower short-term and longer-term inflation expectations, and in reduced
uncertainty and reduced instability in the financial markets. In this way
fiscal policy can enable monetary policy to maintain price stability at
relatively low interest rates.
Over the last year the foreign-currency
market was relatively calm, with some depreciation of the NIS against the
dollar (in the first five months of the year, offset partially thereafter),
some of which was the outcome of changes in cross-rates worldwide. Alongside
the calm in the foreign-currency market, Israel's risk premium stabilized at a
relatively low level, in line with a similar process in other emerging markets;
the exchange-rate risk also continued falling. The changes in the exchange rate
were affected by short-term factors on the one hand, including the narrowing of
the interest-rate differentials and Israelis’ adjusting their portfolios, and
by the persistent rising trend of capital inflow, against the background of the
global economic recovery.
The developments in the foreign-currency
market reflect the changes it has undergone over the last few
years-liberalization that exposed the economy to short- and long-term capital
flows, and the move to what is effectively a floating-exchange-rate regime.
Such an environment, in which the markets react to changes in economic
conditions and reflect them, emphasizes the importance of a responsible and
credible macroeconomic policy, and thereby adds to its efficiency.
The removal of the ceiling on stock of issued
Treasury bills at the end of 2001, combined with the increased use that the
Bank of Israel makes of market instruments, including Repo transactions from
the beginning of 2004, helps make monetary policy more effective, in other
words, enables it to achieve its objectives with relatively modest fluctuations
in the interest rate. This is because these instruments operate in the context
of a wider market, thereby enhancing the policy’s transmission mechanism.
The main policy target for the next year and
the following years is to maintain economic conditions that will enable the
economy to realize its growth potential long term, with a rise in the rate of
employment and a reduction in the degree of poverty. To achieve this the
government must persist in following a fiscal policy consistent with the
targets set-a maximum increase of one percent a year in government expenditure
and a deficit of 3 percent of GDP-so that the government debt/GDP ratio will
revert to the downward path it followed till the year 2000. Monetary policy
will continue to operate to preserve price stability while maintaining
financial stability at the lowest possible interest rate, and will thereby
support a sustainable growth path. The observance of fiscal discipline and a
falling government debt over the next few years will allow that to be attained
at relatively low interest.
The policy to encourage continued growth
while reducing poverty and increasing employment must center round a
significant rise in investment in the infrastructure, with budgetary and
extra-budgetary financing. Due to the extent, complexity and essential need for
such investments, the government’s decision to centralize their handling in the
Ministry of Finance must be implemented. At the same time steps must be taken
that will boost employment directly: tax policy that will increase the
incentive to work, including negative income tax; a significant reduction in
the number of foreign workers, mainly via economic means; a real extension of
the program for finding jobs for the unemployed; the development of services
that will make it easier to go out to work; aid for small and medium-sized
businesses, focusing on the aspect of management follow-up; and increased
investment in education in areas and populations with particularly low rates of
employment. These measures will complement those taken hitherto to reduce the
incentives to stay out of the labor market-which are inherent in allowances
paid to those of working age-and to reduce the number of foreign workers.
In addition to the above, the government
should promote the reforms to increase competition in the economy, including
reforms in the capital and money markets intended to encourage nonbank
financial intermediation, as well as structural changes required to increase
competition in the infrastructure industries.
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
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¦ |
The Consumer Price Index (CPI) rose by 1.4 percent in the first half of
2004 (the period reviewed), and over the twelve months to June 2004 it remained
unchanged. The rise in the first half-year marks the return of inflation to the
target range of price stability, following the 1.9 percent fall in the CPI in
2003. |
|
¦ |
Monetary policy in the period reviewed operated against the background
of a trend change in the economic environment: a rise in inflation assessments
and actual price rises to within the inflation target range, after they had
been below the lower limit of the range in 2003; the depreciation of the NIS
against the dollar, following its appreciation in 2003; and recovery in real
economic activity that started in the second half of 2003, after the long
recession. |
|
¦ |
In the first quarter of 2004 expected inflation for one year and two
years forward rose to within the target range, and assessments regarding
exchange-rate risk remained low. These developments supported continued cuts in
the interest rate, but because of the cumulative reductions in 2003, at a
slower pace than in the past. |
|
¦ |
In April and May expected inflation continued rising within the target
range, as the CPI rose. Yield curves rose and their positive slopes became
steeper, following their decline in 2003 which was due to the reduction in the
deficit, against the backdrop of the rise in yields in the US, and possibly
also related to the government’s use of surplus revenue to reduce taxes. The
combination of changes in several indicators could indicate upward pressure on
prices. These developments prompted the Bank of Israel to halt the process of
interest-rate reduction. |
|
¦ |
The expansion of economic activity that had started in the second half
of 2003 continued during the first half of 2004. The rise in GDP reflected an
increase in exports, private consumption, and investment, while public
consumption fell in the first quarter. The rapid increase in GDP serves to
reduce the output gap. The background to the turnaround in activity was
essentially the rising trend in global demand, combined with the improved
security situation. It was also supported by a better mix of macroeconomic
policy, expressed by a relatively low level of long- and short-term real
interest rates. |
|
¦ |
The budget deficit in 2004 is expected to be 4 percent of GDP, in line
with the target set in the Budget Law, despite the cuts in statutory tax rates
decided upon in the first half of the year amounting to almost one percent of
GDP; this is the result of the turnaround in real activity and the rise in tax
revenues. |
|
¦ |
The foreign-currency market was relatively stable in the period
reviewed, as a result of opposing forces offsetting each other-short-term
factors that acted throughout most of the period to weaken the NIS, and
long-term forces that acted to strengthen it. In the first quarter the exchange
rate was affected mainly by domestic considerations, and in the second quarter,
by global developments relating to the dollar. |
|
¦ |
Nonresidents’ activity in the fist half of 2004 consisted mainly of
sales of foreign currency via long-term financial instruments, that was partly
offset by purchases of foreign currency via short-term instruments.
Israelis, on the other hand,
purchased foreign currency, mainly via long-term instruments, but also via short-term
ones. |
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