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Final version: 10.8.2009
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Inflation Report 2009, AprilJune
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
August 2009
This Inflation Report, covering the first quarter of 2009, is submitted to the government, the Knesset and the public as part of the process of monitoring the inflation rate and comparing it to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.
The CPI rose steeply in the second quarter of 2009, by 2.3 percent, largely due to an 8.0 percent increase in energy prices, and seasonal factors, the most pronounced of which was the 17.1 percent increase in prices of clothing and footwear.
In the first half of 2009 prices increased by 2.1 percent, led by two main categories: energy prices, which increased by 8.1 percent, and housing prices, which increased by 2.8 percent. The rise in the housing component, expressing an increase in rents, which actually started in the middle of 2008, apparently reflects a possible shortage of rental accommodation. The index excluding housing and energy rose by a relatively moderate 1.3 percent (i.e., at an annual rate of 2.6 percent).
Relatively steep price increases are expected in the third quarter in the wake of the increase in indirect taxes and the water surcharge (see below). Despite the above, our assessment at this stage is that the risk of inflation in the next twelve months is low, as there are still forces acting to moderate price increases: the level of demand for domestic production is still far below production capacity; around the world there is substantial excess capacity, a low level of interest rates, and low expected inflation; furthermore, the probability of a sharp depreciation of the shekel, that in the past constituted an inflationary risk factor, currently seems low.
In the last quarter of 2008 and the first half of 2009, economies world wide experienced a serious recession. The decline in activity was accompanied by a significant reduction in world trade, reflecting reduced demand for durables, raw materials, intermediate goods and in particular for final goods. The IMF predicts a 12 percent drop in world trade in 2009. Nonetheless, in the second quarter there were firmer signs that the global recession is approaching its turning point. The expansionary monetary and fiscal policies adopted by most countries started to show results: in the second quarter the global financial crisis eased, share prices rose in stock markets around the world, the credit shortage became less acute, and there were signs of renewed corporate bond and share issues. Global demand and activity, however, are still in a recession.
In the first quarter of 2009, the decline in real activity in Israel's economy that had started in the last quarter of 2008 became more severe, the output gap widened, and the unemployment rate increased. In the second quarter there were indications of a slowdown or even a halt to the decline in activity, and there were several signs suggesting the possibility that in some areas a turnaround was starting (mainly in private consumption and foreign trade). The Bank of Israel Companies Survey for the second quarter shows a moderate decline in total business sector activity, after two quarters of steep drops. Indicators of private consumption show that it was stable in the second quarter, with the possibility of a slight increase, following its decline of 3.9 percent (annual rate) in the previous two quarters. Foreign trade data show a moderation in the decline in goods imports and a modest increase in exports. The fall in direct and indirect tax revenues also moderated in the second quarter.
The rate of unemployment increased to 7.6 percent in the first quarter of 2009, alongside an increase in the participation rate in the labor market, with indications suggesting that the unemployment rate continued to increase in the second quarter. As the decline in demand affects the labor market with a lag, it can be assumed that the rate of unemployment will continue to rise for the rest of 2009. Wages increased in the first quarter of 2009 compared with the previous quarter, but the real wage was about 3.5 percent lower than in the first quarter of 2008. Health tax revenues in April and May were also lower than in April and May 2008, and also lower than in the first quarter, indicating a further drop in wage payments (meaning either a fall in the number of employees or in the wage per employee, or both).
In the first half of 2009 public expenditure declined (against the background of the delay in passing of the budget), but due to reduced activity, there was a greater fall in tax revenues, and the government deficit grew. In the second half of the year government expenditure is expected (and planned) to increase steeply, following the approval of the budget and in light of the underspending in the first half-year, and the budget deficit is expected to increase further. In order to reduce the deficit, the government decided to increase indirect tax rates. This step together with the increased price of water are expected to contribute an increase of about 1 percent in the price level in the third quarter of the year.
In the second quarter the Bank of Israel interest rate was held at its low level of 0.5 percent, a level set in April 2009. At the same time the Bank of Israel continued with its policy of quantitative easing: it bought foreign currency at a rate of $100 million a day, and bought NIS 200 million of government bonds a day. These steps are intended, among other things, to lower interest rates in the economy, (i.e., to reduce the gaps between longer-term market interest rates and the Bank of Israel rate), and to increase the NIS/$ exchange rate, and thereby to some extent to soften the contractionary impact of the global crisis on domestic demand. These steps also moderated the increase in the second quarter in the yield to maturity on long-term government bonds, a development affected by the expected increase in the government deficit and the increase in long-term yields around the world.
The improvement in the financial sector in Israel continued in the second quarter. This resulted from the improvement in the global financial sectors (which were affected by the expansionary policies of central banks around the world) and from the expansionary monetary measures taken by the Bank of Israel. The effect could be seen in the continued rise in share prices and the significant increase in the issue of corporate bonds by the private sector together with the continued narrowing of the gap between their yields and those on government bonds. These developments indicate the reduced market assessment of risk regarding repayment of corporate debt. This conclusion is supported by company responses to the Companies Survey for the second quarter of 2009, showing that the credit constraint on company activity eased.
Data on credit is available up to May 2009. Total credit to the business sector in May reached close to its December 2008 level. On the one hand its stability reflects an increase of 4.9 percent in nonbank credit, after a decline of 2.8 percent in 2008. The development of nonbank credit reflects the increase in corporate bond issues on the Tel Aviv Stock Exchange which occurred at the same time as the reduction of the yield to maturity, as company risk fell. On the other hand, bank credit to the public dropped by 2.4 percent in the first five months of 2009, having increased by 8.0 percent in 2008. The fall in bank credit occurred concurrently with the decline in its cost, and may mean that there is some slack in demand for bank credit.
Inflation expectations for a year ahead increased in the second quarter to around the midpoint of the target range, both those based on the capital market and those of forecasters (following publication of the June CPI, expectations increased further, and came close to the upper limit of the target range). Apparently the increase in indirect tax rates and in water prices, which are expected to affect prices in the third quarter, and the increase in commodity and oil prices in the second quarter, contributed to the increase in inflation expectations. The next few months may see relatively high price increases, with a rise in the rate of inflation (measured over the previous twelve months), but this is expected to moderate later in the year. This, against the background of the continued recession in domestic and global demand, and the slack that is expected to persist for some time, at least in the labor market.
The Bank of Israel continues to monitor developments in Israel and abroad and will act to keep inflation within the target range, while encouraging real activity and supporting financial stability.


Stanley Fischer

Governor, Bank of Israel

Summary*
  Inflation: The Consumer Price Index (CPI) rose in the second quarter of 2009 by 2.3 percent; seasonally adjusted it increased by 1.4 percent. In the last twelve months it increased by 3.6 percent. After a steep decline in the rate of price increases in the last quarter of 2008 and concern over possible deflation as the economy entered a recession ,prices increased at a rate that exceeded the upper limit of the inflation target range ,despite a modest level of real economic activity .The background to the price increases was the increase in world commodity prices, expansionary monetary policy pursued by central banks around the world and in Israel, recovery in the financial markets ,and forecasts that the slowdown in real activity would soon come to an end .Housing prices made a significant contribution to the increase in the CPI over the last twelve months ,but were not a major factor in the second quarter of 2009 .Inflation expectations rose from their low level in the previous quarter, and are currently consistent with the inflation target range.
  Real activity: In the first quarter of 2009 real economic activity contracted, the output gap widened ,and the rate of unemployment increased .The slowdown in economic activity was strongly affected by the fall in exports, reflecting the drop in world trade. Preliminary indicators relating to the second quarter of 2009 suggest a continued decline in domestic demand, albeit at a slower rate, with a small increase in exports. The recovery in the financial markets ,the rise in consumer confidence indices ,and the moderation of the reduction in tax revenues show that the economy is close to the trough of the current business cycle.
  The financial markets: The financial markets recovered in the second quarter of 2009 ,but the risk level remains relatively high. Share prices in the Tel Aviv Stock Exchange (TASE) increased , the risk premium on corporate bonds was reduced, and there was a significant increase in capital raised from nonbank sources. Nonetheless ,these did not revert to the levels prevailing prior to the deterioration of the crisis in September 2008 .The real yield curves of government bonds steepened; short-term real yields fell and became negative, against the background of the low Bank of Israel interest rate, while long-term yields increased. The nominal and real effective exchange rates remained stable, with the shekel appreciating against the dollar and depreciating against the euro.
  Around the world: The effects of the financial crisis are evident in real economic activity, and the advanced economies are experiencing the most severe contraction of real activity in sixty years. That said , there are firmer indications that the global recession is approaching its turning point. In the second quarter the IMF and the OECD revised their forecasts of world growth in 2010 upwards, for the first time in more than a year. Alongside slack levels of activity ,low levels of inflation were recorded, and monetary policy continues to keep interest rates low, with quantitative easing instruments being used.
  Monetary policy: In the second quarter of 2009 ,the Bank of Israel maintained an expansionary policy, using three tools: the interest rate ,purchases of foreign currency ,and purchases of government bonds. At the beginning of the quarter the Bank reduced the rate of interest for April to 0.5 percent, its lowest ever level ,and it has stayed at that level since then. The Bank also continued to buy an average of $100 million a day of foreign currency to increase the level of the forex reserves and to support the exchange rate .In addition, since February the Bank has bought NIS 18 billion of government bonds on the secondary market; at first these purchases were on a relatively limited scale ,and then the rate was increased to NIS 200 million a day .Once the Bank had reached its purchase target-- between NIS 15 billion and NIS 20 billion--it announced that it was ending the program at the beginning of August.
  Forecast: The output gap is expected to widen, despite the initial signs of recovery in the markets, as growth rates are still low compared with the economy's potential growth. GDP is expected to contract by 1.5 percent in 2009 ,and unemployment to average 7.7 percent .In 2010 GDP is expected to grow by 1 percent. Inflation ,measured over the previous twelve months ,is expected to enter the target range in the third quarter of 2009 ,and to remain there for the following twelve months. Its relatively high level in the first half of 2009 despite the recession may indicate a higher inflation environment. The Bank of Israel will absorb liquidity when the conditions show this to be necessary, in order to meet the inflation target.
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* 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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