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Inflation Report 2008, April - June
Letter of the Governor, Professor Stanley Fischer
Bank of Israel Jerusalem
July 2008
The Inflation Report for the second quarter of 2008 is submitted to the government, the Knesset and the public as part of the process of monitoring inflation in relation to the inflation target set by the government. The Report was prepared in the Bank of Israel within the framework of the Senior Monetary Forum, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.
The Consumer Price Index (CPI) rose by 2.2 percent in the second quarter of 2008, and in the previous twelve months by 4.8 percent, significantly above the upper limit of the price stability target range of 1–3 percent inflation a year. Prices during this period were greatly affected by the recent increases in world prices of raw materials, in particular oil and food prices. The acceleration in the rate of price increases in the second quarter occurred in many of the components of the index, due to the broad effect of the rise in fuel and food prices on the production costs of many goods and services, and also against the background of the full employment environment in Israel. The appreciation of the shekel at this time, however, moderated the effect on the CPI of the price rises in imported goods.
In the period under review the Bank of Israel acted to maintain price stability, in light of the slowdown in global activity and concern over global financial instability on the one hand, and accelerated inflation on the other. The Bank cut the interest rate for April by half a percentage point, following a similar cut in the rate for March. The reason for these steps was concern that the global financial crisis would have a serious negative impact on economic activity in Israel, together with the assessment that the expected global growth slowdown would put a halt to the rise in commodity prices and would also contribute to the slowdown in economic activity in Israel, factors that would support the return of inflation to the target range. At that time the annual inflation rate was slightly higher than the upper limit of the range. Towards the end of April, with the CPI higher than expected, the danger of a global financial crisis apparently receding, and National Accounts figures indicating the continuation of rapid growth, the Bank of Israel stopped reducing the interest rate. There was no change in the rate for May, and for each of the months from June to August (decisions made at the end of May, June, and July) the interest rate was raised by a quarter of a percentage point, bringing it to 4.0 percent.
The nominal and real appreciation of the shekel against other currencies continued in the second quarter. This can be partly explained by the combination of increased nonresident investment in Israel, a contraction in Israelis’ investments abroad, and a persistent though declining surplus in the current account of the balance of payments in a full-employment environment. The appreciation of the shekel over the last year combined with an increased level of volatility in the foreign exchange market has significantly weakened the former close link between housing prices and the dollar exchange rate. As a result, the impact of the dollar exchange rate on the CPI has greatly moderated over the past year.
The Bank of Israel continued buying foreign currency in the second quarter, in accordance with its announcement on 24 March regarding its plan to increase the forex reserves. With effect from 10 July the Bank increased the rate of its purchase from an average of $25 million a day to an average of $100 million a day. This decision was made following an examination of the current market conditions and in light of the rapid cumulative appreciation of the shekel.
The main objective of monetary policy is to maintain price stability while contributing to growth and employment, and financial stability. Thus, in a period when there are pressures pushing inflation up on the one hand, and indications of a slowdown in activity on the other, the advantages of a flexible inflation targeting regime become highly apparent. When inflation is outside the target range, the Bank of Israel seeks to return it gradually––typically within a year––to the range, to minimize the potential adverse effects on economic activity and financial stability of attempts to return inflation to the target range very rapidly.
The Bank of Israel’s estimates and those of other forecasters are that inflation will continue to be higher than the target range in the near future, and will return to the range within a year. The upward adjustment to the inflation forecast relative to the forecast in the previous inflation report (for the first quarter of 2008) is mainly due to the continued increase in world commodity prices and the delay in the slowdown in activity compared to the initial expectations. One condition for a slower rate of inflation in the coming year is a moderation in the rate of commodity price rises in that period.
There is currently a high level of uncertainty concerning future economic developments in Israel and there are serious risk factors that could affect both inflation and the level of economic activity, related mainly to the continued global financial crisis and also the economy’s proximity to full employment. The Bank of Israel will continue to monitor current economic developments and assessments of developments expected around the world and in Israel, and will act to maintain price stability while supporting economic activity and financial stability.

Stanley Fischer

Governor, Bank of Israel

Summary1
  The CPI rose by 2.2 percent during the second quarter of 2008. Inflation in the twelve months to the end of June 2008 was 4.8 percent, significantly higher than the upper limit of the price stability target of 1–3 percent annual inflation.
  The deviation of inflation from the target was due largely to the rise in world prices of oil and food in the last few years. As occurred throughout the world, high inflation in the second quarter was led by the energy and food components, but was evident in other components too.
  According to National Accounts data, GDP growth rate in the first quarter exceeded expectations. The continued rapid growth in a full-employment environment, contributed to the deviation of inflation from the target, as it eased the transmission of the increase in production costs to consumer prices.
  That said, some data of the first quarter and initial indicators relating to the second quarter suggest a slowdown in the rate of economic growth, against the background of the global growth slowdown, real appreciation of the shekel, and the full-employment environment.
  The shekel continued to strengthen in the second quarter, helping to moderate the effect on the CPI of the inflation in imported goods. However, in light of the reduced usage of contract indexation to the US$, mainly in housing, the relation between the nominal exchange rate and the CPI continued to weaken.
  The Bank of Israel, like other central banks throughout the world, is dealing with the situation in which on the one hand there are the implications of the financial crisis in the US and Europe, and expectations of a slowdown in economic growth, and on the other, a rise in the inflation environment.
  In the course of the second quarter the Bank of Israel switched from cuts in the interest rate to increases in the rate, as the assessment of the risks changed following higher-than-expected rises in all components of the CPI, indications of calm in the financial markets abroad, and more moderate expectations regarding the slowdown. The worldwide picture changed from one with no uniform direction in central banks’ interest rates to a clearer trend of rising interest rates.
  The interest rate for April was cut by half a percentage point, the rate for May was left unchanged, and the rate for each of the months June to August was increased by a quarter of a percentage point, bringing the interest rate to 4.0 percent. These increases, which were made against the background of the rise in the inflation environment, were moderate because of concern over both the global financial crisis and a future slowdown in growth.
  According to most assessments, including those of the Bank of Israel, inflation (measured over the previous twelve months) will return to the target range within about a year. These assessments are conditional on the moderation of world energy and food prices.
  Under a flexible regime of inflation targeting, the Bank of Israel acts to return inflation to the inflation target range within a year. The Bank of Israel is aware of the risk that the return of inflation to the target range may take more than a year. Further acceleration of world commodity prices, a trend change in the shekel exchange rate, or widespread wage increases, any of these could delay the reduction of inflation. On the other hand, appreciation of the shekel, intensification of the global crisis, a slowdown of economic growth in Israel, or reductions in oil and commodity prices, would act to bring forward the return inflation to the target.
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1 The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, defined as an inflation rate of between 1 percent and 3 percent a year. (For details see Box 1 on page 11 in the Bank of Israel Inflation Report No. 17, July–December 2005.)
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