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Preliminary translation: 3.11.2010
Final version: 7.11.2010
The full document, in PDF file -

Inflation Report 2010, July–September
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
October 2010
This Inflation Report, covering the third quarter of 2010, is submitted to the government, the Knesset and the public as part of the process of assessing the inflation rate in relation 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.
Data relating to the second quarter of 2010 and most indicators relating to the third quarter show continued economic growth––albeit at a slightly slower pace in the third quarter––with inflation, except in real estate, still at a low level.
Unlike the continued slow growth in many advanced economies despite their very expansionary monetary and fiscal policies, in Israel economic activity and employment grew rapidly in the second half of 2009 and the first half of 2010. In Israel, as in most other countries, an extremely expansionary monetary policy was implemented at the end of 2008 and the beginning of 2009, to help rescue the economy from the effects of the global crisis. But unlike in many of the leading economies, the Israeli economy responded quickly to the stimulus. By the end of the second quarter of 2010, the economy was close to pre-crisis levels of activity and employment. The return to growth and the closing of the output gap, accompanied by inflation around the upper level of the target range, necessitated adjustments in economic policy.
The challenge facing policy makers is to determine the pace of interest rate changes and the continued use of additional policy instruments, and in particular intervention in the foreign currency market and supervisory measures, such that the successful economic environment – supportive of price stability, growth, and financial stability -- is preserved without creating longer-term imbalances.
GDP grew at a rapid rate of 4.5 percent in the second quarter, maintaining the buoyant rate achieved since the middle of 2009. Output growth was led by the increase in exports, which are expected to expand by about 10 percent in 2010, following their decline at a similar rate in 2009; they are expected to grow by another 6 percent in 2011, despite the predicted continued sluggishness in Israel’s main trading partners. The impressive recovery of exports is mainly due to companies’ success in retaining existing customers even in target markets experiencing difficulties, while developing trading relations in new markets. The relatively rapid growth was accompanied by increased employment in the business sector and reduced unemployment in the economy, unlike the situation in the US and most Western European countries. Export-led growth was also reflected in the continuing surplus in the current account of the balance of payments. With regard to the budget, the current expectation is that the deficit in 2010 will be between 3.7 percent and 4 percent of GDP, well below the 5.5 percent ceiling for 2010 set when the two-year budget for 2009 and 2010 was approved. This sharply better fiscal performance is mainly a result of the more rapid than expected growth of the economy.
Inflation over the previous twelve months declined to 3 percent in May, and since then it has been within the target range of 1–3 percent a year. Twelve-month inflation forecasts from various sources are for the CPI to rise within the upper part of the target range. One important feature of price developments is the gap that has appeared in the last year between the rise in the housing component of the CPI on the one hand–– 6 percent in the twelve months to September 2010, with an expected increase of up to 8 percent in the next four quarters––and on the other, the relatively slow increase in the other components of the CPI of about one percent in the last twelve months, with a similar increase forecast in the next twelve months.
The general picture of Israel’s economy in the third quarter and also assessments regarding the future is positive. Nevertheless, alongside this positive situation there are some developments that give cause for concern and confront macroeconomic policy with challenges: first, house prices and share prices have been increasing rapidly for more than a year; in each case partly due to fundamental forces––the former because the rate of building is slower than the increase in the number of households, and share prices surging because of the high economic growth rate––but both apparently encouraged by the low rates of interest. In the case of housing, recent rates of price increase, at around 20 percent per annum, are not sustainable, and demand the attention of policymakers. Second, there is serious doubt about the rate of recovery from the crisis in many key economies, particularly the US, and also about the financial strength of several European countries and some states in the US.
Several leading economies, including the United States, leading countries in Europe, and Japan need to continue with a greater or lesser degree of expansionary economic policy, despite their large budget deficits and the marked increase in their public debt. In contrast, there is a group of countries that carry less weight in the global economy, that are showing good rates of growth of output and employment, inflation at or slightly above their domestic targets in goods and services prices, but rapid inflation in asset prices – particularly housing prices – that could pose threats to financial stability. In that group of countries, which includes Australia, Canada, Hong Kong, Norway, Singapore and Israel, the expansionary policies implemented since the peak of the crisis should be reversed more rapidly than in the first group. Typically this also requires increases in the interest rate.
These differences in policy requirements, in particular interest rate policy, create serious problems for policy makers in a world of free capital flows, which are sensitive to interest rate differentials among countries. In the absence of a framework for international coordination of monetary policies, including exchange rate policy, each country has been pursuing its policies independently, combining interest rate changes with an increasing element of intervention in the foreign currency market, leading to policy tensions in the international economy.
Against the background of the unusual increase in uncertainty in the currency arena, the Bank of Israel will continue closely to monitor the broad range of economic developments, and will use the instruments available to it to achieve its objectives of price stability, the encouragement of employment and growth, and support for the stability of the financial system, while keeping a close watch on developments in the housing market, and specially on house prices.


Stanley Fischer

Governor, Bank of Israel

Summary
  Inflation: The CPI rose rather steeply in the third quarter of 2010 (the period reviewed in this report)** by 1.2 percent percent (also seasonally adjusted). The annual inflation rate remained close to the midpoint of the target range, and in September stood at 2.4 percent. The main contribution to the rise in the index, both the annual and the quarterly increase, was from the housing component. The index excluding housing rose by only 1.4 percent in the last twelve months––due to the output gap that still exists and the continued appreciation of the shekel. Inflation expectations for all terms remained close to the upper limit of the target inflation range.
  The global economic environment: Despite relatively favorable National Accounts data for the second quarter of 2010 and an upturn in share prices around the world, uncertainty increased in the third quarter regarding the rate of economic recovery from the crises in the major economies. This resulted from weak labor markets world wide, problems in the US real estate sector, and concern over Europe’s debt crisis. Inflation around the world stayed low despite the steep increase in food prices. All the above led to the expected timing of increases in interest rates being pushed back to the end of 2011, and some central banks even announced additional measures of quantitative easing. In addition, the number of central banks that intervened in their foreign currency markets increased in the third quarter, an issue that became a major topic for discussion in the international arena.
  Real activity: In the second quarter of 2010 Israel’s economic growth continued, based on increases in exports, private consumption and fixed investment, with a marked improvement in employment together with a reduction in the number of hours worked per employee. Indicators of economic activity in the third quarter showed a continued increase, albeit at a slightly slower pace, in light of an apparent reduction in exports. Overall, developments show that the output gap is narrowing, so that its effect on holding back inflation is weakening.
  The exchange rate: Over the third quarter as a whole, the nominal effective exchange rate did not change, with the shekel appreciating against the dollar and depreciating against the euro. This, despite the fact that factors exerting pressure for shekel appreciation––the surplus in the current account of the balance of payments deriving from the strength of the export sector and the differential between Israel’s interest rate and those abroad––persisted. Purchases of foreign currency by the Bank of Israel served to moderate these pressures.
  The financial markets: In line with the worldwide trends, prices of financial assets, and in particular of shares and government and corporate bonds, increased sharply in the third quarter, with a decline in risk indices. The Tel Aviv 25 share price index rose by 16.3 percent. The rise started concurrently with the temporary easing of concern over the debt crisis in Europe, but it continued even when apprehension about the debt crisis grew again.
  The housing market: House prices continued to increase rapidly, reflecting the low interest environment and the supply shortage. Nevertheless, despite the rapid rise, a long-term analysis shows that the level of house prices does not deviate significantly from that derived from the economic fundamentals in the housing market. A continuation of the rapid rate of increase in the future, however, is likely to result in a more significant deviation. Together with rising housing demand, the increase in house prices and the low level of interest, mortgages granted to households are also increasing rapidly, with most housing loans at floating unindexed interest rates. The Bank of Israel’s assessment is that the level of house prices does not constitute a “bubble” and does not pose a real threat to the stability of Israel’s financial system, because of the relatively conservative nature of its banking system. Against this background the Bank of Israel introduced two modest macroprudential steps (the first announced in May, and the second in October) with regard to mortgage loans, intended to prevent the severing of the link of house prices to the fundamentals of the housing market, and to prevent the development of a situation that could create a financial risk.
  Monetary policy: In the third quarter and in the following months the Bank of Israel reduced the extent of monetary expansion, in light of the inflation environment, the pace of the increase in economic activity, and the persistent surge in house prices. It did this by increasing its interest rates for July and October by 25 basis points each, so that the rate in November is 2 percent. The increases in the interest rate widened the differentials between the rate in Israel and those in other countries, thus increasing the pressure for appreciation of the shekel. The Bank therefore increased the rate of interest gradually, while integrating the modest macroprudential measures mentioned above for dealing specifically with the housing market.
  The Bank of Israel Research Department forecast: The Research Department assessment is that inflation in the next twelve months will be about 2.5 percent. The continued rise in the housing component will continue to constitute the main inflationary factor. According to the Bank’s assessment, growth will be 4.0 percent in 2010, and 3.8 percent in 2011, so that the output gap will contract. The unemployment rate, which has declined to the full employment environment, is expected to remain at that low level (about 6.0 percent in 2011). These forecasts are expected to be realized along with the gradual process of increases in the Bank of Israel interest rate.

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