Jerusalem, January 24, 2002
The Inflation Report
1 for the second half of 2001 is submitted to the
government, the Knesset, and the public as part of the process of monitoring
the course of inflation and adherence to the inflation targets set by the
government, and is intended to increase the transparency-and credibility-of
monetary policy. Transparency in the management of macroeconomic policy
is important for enhancing the degree of certainty required by foreign and
domestic investors.
The year 2001 marked the end of a decade in which monetary policy brought
Israel's annual inflation rate down from 15-20 percent to the low rate
accepted in western countries-less than 3 percent. The disinflationary
process in Israel was implemented by the framework of annual inflation
targets, the last of which was set in August 2000 as the range from 1 to 3
percent-defined as price stability-in 2003 and subsequently. At that time,
slightly higher rates were set for 2001 and 2002, the object being to
determine a path of convergence to price stability.
During the years of the inflation target regime the actual rate deviated several
times from the targets; in the distant past the deviation was above the target,
and in the last three years it has been below it. Despite the deviations, this
framework has been very beneficial for Israel's economy, and continues to be
so. Since the public perceives monetary policy as being credible because it is
committed to the inflation target, this has helped to preserve price stability
and financial stability in Israel despite an environment of shocks that
threatened to undermine stability. Nonetheless, as in other countries with
annual inflation targets, inflation cannot be expected to always remain within
the calendar year target because of factors over which there is no control in
the short term and which are described in this report.
Fiscal developments in 2001 gave cause for grave concern. The budget
deficit was far higher than planned, and the share of the government ture of
tax receipts.
The recession currently affecting Israel is largely the outcome of the global
slowdown and the security situation. To enable the country to find itself at a
favorable starting point once the global recovery begins, it is necessary to
maintain stability continuously and to implement the required reforms now.
* * *
On 23rd December the Bank of Israel announced a unique and exceptional
monetary measure by reducing its key interest rate by 2 percentage points.
This was made possible by a combination of circumstances: 1. The
government expressed its readiness to act to restore control of the budget by
slashing the expenditure outlined in its original budget and returning to a
declining deficit path for 2002-2005; 2. The government decided to take steps
in the financial sphere; these included removing the ceiling on the issuance of
government bonds, serving to make monetary policy more efficient and open
up a non-banking money market, making the exchange-rate band still more
flexible by lowering and flattening its lower limit, and completing the
cancellation of foreign-currency control by enlarging institutional investors'
possibilities of diversifying their asset portfolios abroad; 3. Assessments that
the actual and expected inflation rate would moderate, after accelerating in
2001:III, as well as that real economic activity would slow.
Note that the purpose of these economic policy modifications is to help the
economy cope with the slowdown that has resulted from the global slump, in
the US in particular, and also from the security incidents. It is to this end that
agreement has been reached by the government and the Bank of Israel to
alter the macroeconomic policy mix, i.e., greater fiscal restraint, in order to
lower long-term interest, and looser monetary policy, in order to reduce
short-term interest. It was also decided that measures would be introduced in
the money, and foreign-exchange markets.
It is unreasonable to expect the current level of short-term interest-rate
stability to be maintained if all the other components of policy are not
implemented as planned. Assessments to this effect will be expressed in the
public's response in the financial markets, foremost among them the markets
for foreign currency and bonds, as well as in Israel's credit rating in the world.
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1 This 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 15.9 percent rise in the money supply from December 2000 to
December 2001. The development of the monetary aggregates is described
in section IIa 7-10 of this report.
David Klein
Governor
Summary
* During the second half of 2001 (the period reviewed), the Consumer Price
Index (CPI) rose by 0.3 percent, bringing the cumulative rise for the year to
1.4 percent. This is below the inflation target for the year, but is in line with
the long-term target of price stability, i.e., 1-3 percent inflation.
* Developments in the period reviewed took place against the background of
greater uncertainty in Israel and abroad, and the increased severity of the
slowdown in economic activity, mainly in the last quarter. In Israel the
deterioration resulted from the worsening of the worldwide situation following
the terrorist attacks on the US in September, and also from the continuation
of the intifada. These served to moderate price increases, but also increased
the degree of uncertainty and the economy's vulnerability.
* The government's fiscal policy was another cause of greater uncertainty in
the period reviewed. The budget deficit at the end of 2001 was 4.6 percent of
GDP, while the planned deficit had been 1.75 percent. It also became
apparent that according to the budget for 2002 approved by the government
in September 2001, a deviation from the planned deficit would occur again in
2002. This expansionary policy and the lack of consistent efforts by the
government to achieve decreasing government debt and deficit targets to
reach the norms in advanced countries made it impossible to adopt a more
expansionary monetary policy without endangering stability.
* In these circumstances interest-rate policy continued to follow the path of
steady, cautious reductions. From July until 25 December the interest rate
was reduced by one percentage point, and since the beginning of the year by
a total of 2.4 percentage points. The moderate pace of reductions was aimed
at providing a firm foundation for price and financial stability, particularly in the
light of the rise in the degree of uncertainty during the period
reviewed-especially in the third quarter-which threatened to undermine
stability.
* Against the background described above, the stability of the domestic
foreign-currency market stood out like a beacon. The NIS depreciated against
the dollar in 2001:III by a cumulative 4.5 percent, and in 2001:IV the trend
reversed into one of appreciation. The changes in the exchange rate
occurred with low volatility and spreads and with relatively high levels of
trade. This behavior of the foreign-currency market, particularly in the light of
the sharp drop in foreign investments, was the result of the greater
sophistication and deepening of the market.
* On 25 December the Bank of Israel cut the rate of interest by an exceptional
2 percentage points. The background to this unusual step was the
government's decision to return to the declining government-debt path,
cutting the expenses in the original budget for 2002, and setting a
downward-sloping path for the budget deficit until 2005. The exceptional cut
in the interest rate was intended to help the economy recover from the
recession as evidenced by growing unemployment and reduced inflation. The
cut in the interest rate was accompanied by other measures-decided upon in
cooperation with the government-designed to help develop the financial
markets and increase their flexibility. The decision to make an exceptional cut
in the interest rate was taken in the light of a combination of special
circumstances; in the future, the monthly interest-rate decisions will again
adjust the rate gradually in order to maintain price and financial stability.
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