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Is the Israeli Economy in the Midst of a Deflationary Process? The Consumer Price Index (CPI) declined 1.9% in 2003,. The fall in the CPI over recent months has raised concerns regarding deflation in Israel. This phenomenon has been a frequent topic of discussion with regard to Japan, which has been suffering from a decline in prices for many years now. There has been growing concern recently at the International Monetary Fund (IMF) regarding deflation in several other countries, including China (especially the area around Hong Kong), Germany, and Switzerland. Does recent data on Israel justify the current fears that Israel is suffering from deflation? Those who believe that Israel is indeed in the midst of a deflationary process support their claim primarily on the following underlying conditions in the Israeli economy: (1) the fall in the CPI, (2) the deep recession in the economy, (3) the rise in unemployment, and (4) the erosion in wages. This article reviews the principle causes behind deflation and analyze to what degree it is reasonable to presume that the Israeli economy is in the midst of a deflationary process. Deflation is defined as a continued decline in price levels within an economy, while at the same time the economy deviates from the level of full employment. The use of the term 'price levels' is general and should be across the whole width of the index, reflecting all major price indices, including the consumer price index, the producer price index, the wholesalers' price index of industrial production, the residential construction inputs price index, and others. A decline in prices Diagram1: Consumer Price Index year on year rate of change 10% 8% 6% 4% 2% 0 -2% -4% I V 1999 IX I V 2000 IX I V 2001 IX I V 2002 IX I V 2003 IX The CPI declined by 1.9% in 2003, bringing inflation to its lowest since the establishment of the State of Israel. Nonetheless, it appears that the country is not facing a prolonged process of price declines and during 2004 the rate of inflation is expected to be within the target range set by the government. Diagram 2: Main Price Indices: year on year rate of change 10% 8% 6% 4% 2% 0 -2% -4% I III 2002 V VII IX XI I III 2003 V VII IX XI Consumer Price Index Residential Construction Inputs Price Index Wholesale Price Index The three main price indices published by the CBS do not point to uniform trends. The declining trend is evident only in the CPI. This finding supports the view that the Israeli economy is not in the midst of a deflationary process. 13 over a period of a few months should not arouse any concern. However, if the declines continue for an extended period of time, then the implementation of proper policy steps is required in order to stop the decline in prices. Currently in Israel, only the CPI is declining; all other price indices are recording increases (see diagram number 2). Both a demand side and supply side shock can be the driver behind deflation. When the shock originates from the demand side, it is logical that the decline in prices will be accompanied by a decline in production and employment. In contrast, when the shock originates from the supply side, it is possible that there will be an expansion in production together with the price declines. However, irrespective of the source of the shock, deflation shifts the distribution in income from borrowers to lenders. In addition, deflation can disrupt stability in the financial system. The costs of deflation to an economy depend on three factors: (1) whether the source of the shock derives from the supply or the demand side, (2) the level of deflation, and (3) the length of time in which prices continue to decline. When the source of the shock is from the supply side, for example a technological improvement or a drop in the price of imports, then the negative implications of deflation are minimal. In this case, it is not likely that the public will form expectations for a continued decline in price levels. Therefore, no negative impact on aggregate demand is expected. However, when the source of the shock is a sharp and continuous decline in demand, the implications for the economy are much more severe and there is an increased chance for a continued decline in prices. Deflation that originates from a decline in aggregate demand, in the event it continues for a significant amount of time, will negatively impact production and employment. It can LEUMI REVIEW ISRAEL: MACROPERSPECTIVES 144 also develop its own deflationary 'inertia' and thus continue to lead to degeneration of the situation. The destructive impact of deflation was felt in the world at its fullest during the Great Depression in the 1930s. During that period the industrialized nations suffered from unprecedented deflation as prices fell by approximately 25% in Britain, by approximately 30% in the US and Germany, and by approximately 40% in France. Unemployment reached catastrophic levels and the human toll was immense. The underlying background conditions in Israel, which have supported a decline in prices over the last year, originate mostly from the demand side. The principle factors which have restrained demand in the economy include: (1) the increase in the level of unemployment and the fear of many that they may join the growing ranks of the unemployed; (2) the security situation and its contribution to the uncertainty towards the future; and (3) the slowdown in the global economy, which is beginning to show signs of a recovery, but is still uncertain. In addition, it is still unclear how quickly the global recovery will impact the high-tech sector, a very significant sector in terms of Israeli export. The slow expansion in credit in the economy, and the tight monetary policy by the Bank of Israel over the last year are other factors restraining demand. All of these factors, and others, have an impact on households and firms, which is expressed by a decline in demand for both consumption and investment. In addition, there is an impact from the supply side, which has been supporting a decline in prices. Cheap imports, particularly from China, are pressuring prices downward. The weakness of the US dollar in global markets is also contributing to the relative strength of the shekel. The strength of the shekel has a significant impact on the CPI, principally through the housing component (a dollar denominated market). In addition, the increased level of productivity in the business sector, stemming from efficiency measures taken over recent years, has expanded supply and thus further supported price declines. The rate of inflation in Israel is expected to continue to be low in the coming months. However, a prolonged process of price declines such as that seen in Japan is not likely. One of the required conditions for price declines to become chronic is for the public to have negative inflation (deflation) expectations. If the public expects the level of prices will continue to decline in the future, people will reduce expenditures today with the expectation that they will be able to buy more goods and services in the future with the same amount of money. Such behavior will only nourish the deflationary process since delaying purchases reduces demand in the present and thus supports further price declines. Within the yield spreads between shekel bonds and T-bill on one hand and CPI-linked bonds on the other we can see that inflation expectations are low for the next twelve months on the Israeli capital markets. However, despite the continuation of declining price indices, inflation expectations remain within the price stability range set by the government of 1-3% (from 2003, see diagram number 3). This means that the Israeli public relates to the negative inflation of 2003 merely as a passing phenomenon, and not as an on-going process that is expected to continue into 2004. The chances that the public will develop expectations for negative inflation in the future are slim, especially considering that monetary policy continues to be less restrictive, as seen in the recent relative rise in the level of monetary instruments. One of the dangers for an economy suffering from a deflationary process is the central bank's inability to respond. This inability to react occurs when the nominal interest rate approaches zero. In this situation the real interest rate in the economy continues to rise, and monetary policy cannot act to bring it down. At very low interest rate levels, monetary expansion is likely to be ineffective since at very low interest rates the public demand for money is infinitely elastic, a situation known as a 'liquidity trap.' The interest rate of the Bank of Israel is currently set at 4.8%, a level that still reflects a relatively high real interest rate. This high interest rate gives the Bank of Israel additional "ammunition" to act in the event that the CPI continues to decline and stays below the lower level of the price stability target. The CPI is expected to continue to decline in the coming months, compared to the same period last year. Nonetheless, it appears that a return to price increases, although moderate, will occur gradually during the first half of 2004, such that the rate of inflation will return to within the range of the government's price stability target. Diagram 3: Market Based Inflation Expectations for the next 12 Months 8% 6% Inflation Target Range (1 - 3%) 4% 2% 0 I VII 1998 I VII 1999 I VII 2000 I VII 2001 Inflation Expectations fot the Next Twelve Months I VII 2002 I VII 2003 Trend Despite the decline of the CPI, expected inflation, based on market data, do not point to similar developments. Moreover, during 2003, inflation expectations for the next 12-months were in the center of the inflation target. It appears that the public, despite its tendency to be rather adaptive, did not consider the decline of prices to be a prolonged process, and viewed it as a transitory development. 15