Israel's Inflation Target Policies - Historical Perspective and Future Outlook Introduction

Transcription

1 Israel's Inflation Target Policies - Historical Perspective and Future Outlook Introduction Israel's Consumer Price Index (CPI) rose by 6.5% in 2002, sharply overshooting the government's inflation target of 2-3%. Most of the rise in the CPI occurred in the first half of the year, followed by price stability in the second half as a result of a significant hike of the interest rate by the Bank of Israel, combined with additional economic policy steps. From 2003 onwards, the government will no longer set a declining inflation target over time, but instead will seek long term price stability within an annual range of 1-3%. With this background, how should investors, borrowers, and other relevant parties relate to the inflation target? We believe the answer to this question depends on the economic policymakers' commitment to price stability. If the policymakers regard the target as a central goal and accordingly implement the necessary policy steps, then the target will remain a good indicator for basing long-term assumptions. The Origins of Israel's Inflation Target In mid-1985, the rate of inflation was fast approaching an annual rate of 450%. Risks of crossing over into hyperinflation (with annual inflation rates of thousands of percent) were becoming more tangible. The government implemented a stabilization program that succeeded to quickly reduce inflation to 16-20% between The stabilization plan was based on a combination of factors including a reduction in fiscal outlays, a tightening of monetary policy, a wage freeze that was achieved by a temporary suspension of the cost of living allowances, and a temporary price freeze on various goods and services. The plan did not include the establishing of an inflation target. Instead, the exchange rate of the shekel was frozen in order to establish a nominal anchor in the economy, at the price 18% 16% 14% 12% 10% 8% 6% 4% 2% 0 Diagram 1: Inflation Targets and Actual Inflation* -2% * Official inflation targets are marked by horizontal lines. Actual inflation-cpi change, year over year The disinflation and price stability convergence process in Israel has come to its final stage in From this year onwards the 1-3% annual inflation target will remain unchanged and this is defined as Israel's price stability target. Over the years the rate of inflation has been volatile and occasionally deviated from the inflation target. Nonetheless, on average, since its inception, the inflation target has been met accurately. 19

2 of a significant real appreciation of the shekel. A real term appreciation of the shekel during the second half of the 1980's, caused by the freezing of the exchange rate or limiting its movement within a narrow range, began to quickly erode Israel's competitiveness. The public began to express its doubts regarding the ability to sustain this policy on the long term, thus requiring a new, reliable nominal anchor. Under these conditions, in December 1991, the idea of formulating a diagonal, crawling, currency band was born. From a practical standpoint, the establishment of a crawling currency band that would help to maintain Israel's competitiveness, demanded an inflation target. This is because the rate of crawl of the band, that is to say, the minimum rate of depreciation, is determined by the gap between the targeted inflation rate in Israel and the expected rate of inflation overseas. This approach is intended to guarantee that, on average, the crawling currency band would maintain the real rate of exchange of the shekel. Thus, through "the back door," almost completely in secret, Israel's first inflation target was established in late 1991 with a target of 14-15% for Israel's implementation of an inflation target, in comparison to comparable moves by other countries, was unique in two aspects. First, the harsh memory of triple-digit inflation from the first half of the 1980's was still fresh in the minds of policy makers when deciding on the first inflation target for Second, at the time of implementation there was a high level of vagueness regarding the operational meaning and character of the inflation target. It is likely that this vagueness regarding the demands of the target, and the implications for economic policy, was a result of the fact that the inflation target was only an accompaniment to the crawling currency band, instead of being a primary policy goal. Target Characteristics The target is set in relation to the CPI in its entirety, and relates to changes throughout the year. That is to say, it relates to the rate of change of the CPI from December to December, and not to the average level of the CPI during the year in relation to the average during the previous year. Inflation targets over the years have been declining (see Diagram 1, page 19). With this said, the declining trend was not predetermined, and up until recently there was no multi-year inflation target. In other words, the target has been set in most cases only the year before, usually towards the end of the year, with no consideration to the gap in time between the implementation of economic policy and its impact on inflation, a period of time which can be relatively long. In most cases, the target for the coming year was set slightly below the inflation rate of the previous year. In other words, the target rate set for each year depended on the rate of inflation in the previous year and partially on forecasts for the coming year. This adaptive approach seems to have contributed to slow disinflation during most of the inflation target period. For several of the years, the target rate was defined in terms of a range, and not a specific rate, due to the difficulty in "hitting" a pinpoint target. LEUMI REVIEW ISRAEL: MACROPERSPECTIVES 143

3 Inflation Target Performance Since its Introduction and Implementation Table 1 displays the annual inflation targets and the actual inflation rates for the years since implementation through As shown in the table, the target rate moved from double-digit figures to a single-digit rate only in This 4% target was set in 1998 in light of the fact that this was the rate of inflation for most of that year, prior to a sharp, though temporary, depreciation of the shekel late in the year. Israel's transition to single-digit inflation, as seen by the target rates and actual inflation, was a slow process that took close to seven years. This was preceded by seven years ( ), in which there was no target rate policy, of doubledigit inflation of 16-20% per year. Since implementation of the inflation target in 1992 and through 2002, there have been three years in which there was no deviation from the target, four years in which there was a deviation below the lower limit of the target range, and four years in which there was a deviation above the target range (Table 2). In absolute terms, the rates of deviation above and below the target ranges are identical. We believe the deviations in the actual inflation rates from the targets (both above and below the target) throughout most of the period, were in part due to the lack of a multi-year target that would have allowed for the use of long-term economic policy. Table 1: Inflation target and Actual inflation rate Inflation target Actual inflation % 9.4% % 11.2% % 14.5% % 8.1% % 10.6% % 7.0% % 8.6% % 1.3% % 0.0% % 1.4% % 6.5% Table 2: Inflation target performance Average deviation Years during which the from target during Number of rate of inflation was: these years years Above the target 2.8% 4 Below the target -2.8% 4 Within the target range - 3 Total 11 One of the more interesting findings that arises from analyzing the performance of the inflation target is that, on average, throughout the period of its implementation, the target was achieved precisely. That is to say, the target inflation rate was achieved on average despite difficult economic conditions including a sharp depreciation of the shekel in 1998, and a significant rise in the price of housing during the immigration wave to Israel in the first half of the 1990's. 21

4 Table 3: Period averages Inflation target Actual inflation Target Range % 7.1% % % 10.8% % 7.8% 7-10% % 2.3% % 6% 5% 4% 3% 2% 1% 0% Diagram 2: Long Term Market Based Inflation Expectations* Average * The difference between yields to maturity of shekel bonds (Shachar) with 8-9 years to redemption and CPI-linked bonds with similar terms to redemption The spread between yields to maturity on non-linked shekel bonds and CPIlinked bonds represents inflation expectation for the term and a risk premium factor. Over the past few months there has been a marked decline of the spread following the rapid decline of the inflation risk premium that was triggered by the improvement in the geopolitical outlook and the approval of the government's economic program. Table 3 displays annual averages of the rate of inflation versus the target during several different periods. As can be seen, the average annual target rate of inflation during was 7.4% (based on an average target range of 6.7% to 8.0%), and the average actual inflation rate during the same time period was 7.1%. This finding is important because it supports the belief that in the long term, an explicitally targeted inflation rate may be a credible forecast of future inflation. Of course, this conclusion is based on the firm commitment of policymakers to the inflation target, for without this commitment it will be impossible to take the necessary policy steps to minimize any deviation from the target. Breaking the entire time period since implementation into sub-periods, we see that in the initial period from the average actual rate of inflation was above the target: 10.8% versus an average yearly target of 10.2% (Table 3). This may reflect the lack of a clear distinction at the time between setting the target purely as a forecast tool, that would or would not materialize, and as a target that should be accomplished through actively implementing effective policy. In the years the average actual rate of inflation was 7.8% per year, which was below the average level of the target rate, defined as a range of 7-10%. Achieving the target, despite the sharp depreciation of the shekel during 4Q98, was the result of economic policy, specifically monetary policy, for the purpose of attaining the target. In the years , the average annual rate of inflation was 2.3%, which was below the target that had an average lower range of 2.5% and an average upper range of 3.5%. This deviation, below the target, was the LEUMI REVIEW ISRAEL: MACROPERSPECTIVES 143

5 result of a very low rate of inflation in of 0.7% per year on average and a sharp increase to 6.5%, well above the target, in Future Outlook As stated previously, in the long term, on average, the targeted inflation rate was achieved quite precisely. The most important implication in regards to the future is that as long as the inflation target remains a central goal of economic policy, it seems to be safe to assume that the inflation target will be achieved, on average, in the long term. Accordingly, the inflation target rate can play an important role in long-term planning for investments, borrowing, and other business activities that are sensitive to the rate of inflation. In early 2003 the markets displayed little confidence in the inflation target as a reliable forecast tool for future inflation in the long term. This vote of non-confidence can be seen from the gap of over 5% between the yield to maturity on long and medium term shekel bonds and the yield to maturity on CPI-linked bonds for the same periods (Diagram 2, page 22). This gap, which reflects inflation expectations and the inflation risk premium, was almost twice that of the upper range of the 1-3% price stability target as set by the government. In other words, the market had factored in a high risk that the rate of inflation will consistently deviate from the higher range of the target, year after year, for an extended period of time. This market statement was in sharp contrast with the experience of the last 11 years in which the inflation target rate was achieved almost precisely, and this under difficult macroeconomic and other conditions. During the later part of the first quarter of 2003, the gap between long term unlinked bonds yields and CPI linked bond yields (i.e. long-term inflation expectations and the risk premium) started to decline. By May 2003 the gap was about 3.5%, just slightly above the upper limit of the 1-3% long terms target. It appears that this development took place as a result of a decline in the degree of uncertainty in the markets. In addition, the formation of a new government and the initial economic steps taken by the newly elected policymakers have helped as well. Will long term inflation expectations and the risk premium continue to decline and remain at a low level? To a large extent the answer is in the hands of policymakers that must provide proof of their commitment and the ability to guarantee the continuation of the inflation target and the implementation of policy that will achieve that target, even in the face of an additional deterioration of the situation, economic or otherwise. 23