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Inflation Report 2010, October-December
Letter of the Governor accompanying the Inflation Report
Bank of Israel Jerusalem
February 2011
This Inflation Report, covering the fourth 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.
In the fourth quarter of 2010 the recovery of economic activity and employment that had started in mid-2009 continued, and indications of increased inflationary pressures are evident. The CPI increased by 0.7 percent in the fourth quarter of 2010; excluding the seasonal components––fruit and vegetables, and clothing and footwear––it increased by 0.2 percent in the quarter. The 1.4 percent increase in the energy and food components of the index was faster than that in the other items, and they pulled the overall index upwards. The housing component (based on rentals), the prime inflationary factor in the previous months, moderated in the fourth quarter. Inflation over the previous twelve months increased slightly in the fourth quarter compared with the third, to 2.7 percent. According to the survey of house prices, the purchase prices of houses accelerated in October–November following two months of slower increases.
Indicators of real economic activity in the fourth quarter––from the Bank of Israel Companies Survey, the composite state-of-the-economy index, and nowcasting models for that quarter––pointed to a continuation of the trend of expansion at a rate similar to that in the previous quarter. According to the latest data available, investments and exports increased rapidly, and private (including current) consumption increased moderately after remaining stable in the third quarter. The forecast for the fourth quarter is partly based on the National Accounts data for the third quarter, which showed a GDP growth rate of 4.4 percent, steady private consumption, continued rapid increase in investment, and stable goods and services exports.
Labor market data for the third quarter of 2010 and indicators relating to the fourth quarter show a relatively low rate of unemployment (from a historical perspective), although it did increase in the fourth quarter as a result of a higher participation rate in the labor market. At this stage, however, no significant wage pressures are evident. Although the real and nominal wage both increased in the third quarter, unit labor costs (which take labor productivity into account) declined in that quarter. The Companies Survey, however, shows companies in most industries reporting greater (albeit only slightly greater) difficulty in recruiting skilled workers, indicating a convergence to full employment.
The growth trend in the global economy continued in the third quarter of 2010. Growth in the advanced economies, however, is still low relative to potential, despite the increased growth rate in the US and Japan in the third quarter. In Europe the growth rate slowed a little, and the labor markets in the advanced economies are as yet showing no signs of recovery, and rates of unemployment are still high. Several indicators suggest that the faster recovery in the emerging market economies (faster than in the advanced economies) continued in the fourth quarter, and against that background the increases in interest rates in the emerging markets together with the fact that the expected timing of increases in interest rates in the advanced economies (mainly in the US and Europe) was put back to the end of 2011 continued to encourage capital inflows into the emerging markets, as well as into Israel.
In the course of the fourth quarter the Bank of Israel continued with the gradual process of increasing the interest rate, with the primary intention of firmly settling the inflation rate within the target inflation range, while supporting economic activity and preserving financial stability. Thus the interest rate for October was increased by 25 basis points to 2 percent, and was kept at that level in November and December, as well as in January of 2011. Consistent with the monetary policy goals and particularly with the recent increase in inflation expectations, the Bank of Israel further increased its interest rate to 2.25 in February 2011.
Balance of payments figures show that in the fourth quarter the flow of capital into Israel mainly took the form of purchases of makam (short-term bills issued by the Bank of Israel) and deposits in Israeli banks by nonresidents rather than direct investments (FDI) or purchase of shares. This brought the share of makam held by nonresidents to about a quarter of the total stock of makam. The implication is that this capital inflow, which is motivated mainly by short-term considerations, affects the exchange rate. In order to reduce the influence of the short-term inflows on the exchange rate, the Bank of Israel has been intervening in the foreign exchange market.
In order to improve its ability to analyze transactions and trends in the foreign exchange market, the Bank of Israel imposed in January 2011 a reporting obligation on Israeli residents and nonresidents who perform transactions in foreign exchange swaps and forwards of more than $10 million in one day. Nonresidents who perform transactions in makam and short-term government bonds of more than NIS10 million in one day are also required to report details of the transactions. In addition, to strengthen the Bank of Israel’s ability to achieve the objectives of its monetary, foreign exchange and financial stability policies, the Bank of Israel further imposed a reserve requirement on banking corporations for foreign exchange derivative transactions with nonresidents. A 10 percent reserve requirement applies to NIS/foreign exchange swap transactions and NIS/foreign exchange forwards.
The nominal effective exchange rate of the shekel and the real exchange rate remained basically unchanged at the beginning of the fourth quarter, but in the second half of the quarter they showed appreciation of the shekel, following the widening of the interest rate differential between Israel and the leading economies in October, and against the background of the surplus in the current account.
In light of the considerable increases in house prices (relative to the overall increase in the CPI) and in the volume of housing credit, and despite assessments that there was no bubble in the housing market, in October 2010 the Bank of Israel introduced macroprudential measures aimed at increasing the interest rate on floating interest rate mortgages, aimed at reducing the exposure of the public and the banks to interest rate and credit risks in the housing market.
The main dangers confronting Israel’s economy are: (a) the uncertainty in the global economy regarding growth, particularly uncertainty about the handling by some European countries and the US of their fiscal deficits (the degree of fiscal consolidation required and their ability to implement it), and its effect on the global economy and particularly on Israel’s economy via the demand for Israel’s exports; and (b) the apparent upward trend in prices in the commodity markets around the world, which is likely to boost inflation world wide and in Israel.
The Bank of Israel will continue to monitor economic developments in Israel and world wide and will continue to act to keep inflation within the target range, while supporting real economic activity and financial stability. The path of the interest rate will be determined in accordance with the future inflation environment, economic conditions, global developments, including the path of interest rates abroad, and taking into account developments in the exchange rate of the shekel.


Stanley Fischer

Governor, Bank of Israel

Summary
  Inflation: The CPI rose by 0.7 percent in the fourth quarter of 2010 (the quarter reviewed). The main reason for the rise in the index was the increase in energy and food prices, against the background of their increases world wide. The rate of inflation over the previous twelve months was within the inflation target range, and in December it was 2.7 percent. Inflation expectations for all periods were close to the upper limit of the inflation target range throughout the period reviewed.
  The global economic environment: The recovery process in the global economy continued during the fourth quarter, with the emerging market economies growing faster than the advanced economies. At the same time there was a rise in the risk level of European countries experiencing debt crises. Against the backdrop of different rates of growth, interest rates were higher in the emerging economies than in the advanced ones, which encouraged the flow of capital into the former and in some of them led to more active policies of intervention in the foreign currency markets and the imposition of restrictions on capital flows. In light of the low rates of growth in the major advanced economies and uncertainty about their sustainability, their central banks are expected to start increasing their interest rates only at the end of 2011.
  Real activity: In the third quarter of 2010 Israel’s GDP grew by 4.4 percent (in annual terms), lower than the rate in the third quarter, due to a slower increase in exports and a decline in private consumption. Indicators of economic activity in the fourth quarter point to continued growth at a rate similar to that in the third quarter.
  The exchange rate: At the beginning of the fourth quarter the nominal effective exchange rate showed no significant change, and in the second half of the quarter it reflected shekel appreciation of 4 percent, against the background of the interest rate differential between Israel and the leading economies, and the surplus in the current account.
  The financial markets: Share price indices in Israel increased in the fourth quarter, in line with the trends in the leading stock markets, and in contrast with developments in those European countries which were experiencing debt crises, where the risk level rose and share prices fell.
  Monetary policy: In the fourth quarter of 2010 the Bank of Israel continued along the path of gradually returning the interest rate to its normal level, with the intention of firmly settling inflation within the target range, while supporting real economic activity and maintaining financial stability. To achieve its policy objectives, the Bank of Israel employed a variety of the tools available to it––its interest rate, intervention in the foreign currency market, and macroprudential measures. The Bank increased the rate of interest for October by 25 basis points, to 2 percent, and kept it at that level up to and including January 2011, increasing it again for February, to 2.25 percent. In the course of the fourth quarter the Bank bought about $5.2 billion, partly countering the forces acting to strengthen the shekel. After the end of the quarter reviewed herein, the Bank of Israel imposed an obligation on nonresidents to report derivative transactions in foreign currency or makam (short-term Bank of Israel bills), and on Israelis to report certain foreign currency transactions. The Bank also imposed a liquidity requirement on banks for derivative transactions in foreign currency vis-à-vis nonresidents. In light of the rapid increase in house prices and the amount of housing credit, and because of their possible effect on the stability of the financial system, the Bank of Israel Supervision Department introduced measures to reduce the financial risk in the housing market (macroprudential steps).
  The Bank of Israel Research Department forecast: The Research Department assesses that inflation in the next twelve months will be 2.6 percent, with the interest rate increasing gradually to reach 3.3 percent in the last quarter of 2011.

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