Download Is the Israeli Economy in the Midst of a Deflationary Process?

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.
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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
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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.
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