The Long Journey from High Inflation to Price Stability: The Case of Israel

Price Stability and Financial Developments Central Bank of Argentina

Dr. Karnit Flug Governor of the Bank of Israel September 19th - 20th 2016

1 Inflation Since the Establishment of the Bank of Israel

Actual inflation (12-month) 1954 - 2015 500% Acceleration Stabilization Disinflation Price Stability 450% 400% 350% 300% 250% 200% 150% 100% 50% 0% -50% 1981 2011 1954 1957 1963 1966 1969 1972 1975 1978 1984 1987 1993 1996 1999 1960 1990 2014 2002 2005 2008

2 Source: Bank of Israel. “Acceleration”:(1954 to 1985) Israel’s Public Finances - Root Cause of High Inflation

Actual inflation (12-month) Israel’s government debt % (1983-1990, % of GDP) 480% (1954 – 1984) 444,9% 300 400% 250 320% 200 240% 150 160% 100 56,2% 80% 7,5% 50 0% 0

1954 1956 1958 1962 1964 1966 1968 1972 1974 1976 1978 1982 1984 1960 1970 1980 1983 1984 1985 1986 1987 1988 1989 1990 Israel’s government deficits % Israel’s government public % (1980-1990, % of GDP) 20 expenditure 80 (1980-1990, % of GDP) 15 70 60 10 50 40 5 30 0 20 10 -5 0 19801981 198219831984198519861987198819891990 19801981198219831984198519861987198819891990

3 Source: Bank of Israel. The 1985 Stabilization Plan

Agreement between the government, industry and trade unions

Reduce deficit

Freeze wages and government-controlled prices

Fix the exchange rate after a one-time 25% devaluation

Law prohibiting the BOI from printing money to finance deficit

 $1.5 billion in aid from the US 4 From “Disinflation” toward “Price Stability”

Actual inflation (12-month) 1986 - 2016

25

20

15

10

5

0

-5 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

5 Source: Bank of Israel 1986 to the End of 1991: Inflation is “Stuck” in the 16-20% Range

 1986: ER was set as nominal anchor. The inflation rate remained high; erosion of competitiveness; repeated devaluations  1989: ER is unsustainable as an anchor an ER band was established  1990: An external shock (immigration) led to a substantial decline in inflation

% Actual inflation (12-month) The ER band & 26 1986 - 1992 3,0 currency basket 24 1986-1992 22 2,5

20 2,0 18 1,5 16 14 1,0 08/86 02/87 08/87 02/88 08/88 02/89 08/89 02/90 08/90 02/91 08/91 08/86 02/87 08/87 02/88 08/88 02/89 08/89 02/90 08/90 02/91 08/91

6 Source: Bank of Israel. End of 1991 Onward – Gradual Move Toward IT End of 1991: Moderate reduction in nominal interest rates; real rates Opportunistic approach to disinflation Introduction of the ‘diagonal’ crawling ER band—the slope was set according to IT, defined by the government The nominal strategy changed:  Fixed ER replaced by IT as an anchor  ER and interest rate as policy tools

The ER band & % Actual inflation (12-month) 25 1989-2000 currency basket 5,5 1989-2000 15 4,5 3,5 5 2,5 -5 1,5 01/89 09/89 05/90 01/91 09/91 05/92 01/93 09/93 05/94 01/95 09/95 05/96 01/97 09/97 05/98 01/99 09/99 05/00 01/89 09/89 05/90 01/91 09/91 05/92 01/93 09/93 05/94 01/95 09/95 05/96 01/97 09/97 05/98 01/99 09/99 05/00

7 Source: Bank of Israel. 1992 to 2000 - Taming Inflation: How Did Inflation Drop to Zero?

Government opted for gradual disinflation.

Fear of the sacrifice ratio—the price paid in unemployment to reduce inflation.

Diagonal ER band + IT anchoring inflation.

8 The Battle Over Low Inflation: 1996- 1998  By 1996, the Bank of Israel was seeking to reduce inflation at a faster pace than the government thought was proper  Tight monetary policy exchange rate forced to the lower bound  BOI sterilized FX intervention maintained high interest rates and lowered inflation.  Intensive use of Bank of Israel short-term securities to sterilize

9 Disinflation and Price Stability Achieved by Tight Monetary Policy, 1996-1998

Real BOI interest rate Actual inflation 14 (Annual rate, percent) 14 (12-month)

12 12

10 10 Ex Post

8 8

6 6

4 4

2 2

0 0 11/96 11/97 11/98 11/96 11/97 11/98 01/96 01/97 01/98 01/96 01/97 01/98 03/96 05/96 07/96 09/96 03/97 05/97 07/97 09/97 03/98 05/98 07/98 09/98 03/96 05/96 07/96 09/96 03/97 05/97 07/97 09/97 03/98 05/98 07/98 09/98

10 Source: Research Department, Bank of Israel. The Exchange Rate Band and the “Great Sterilization” 1996–1998

NIS The exchange rate band NIS million BOI assets and liabilities 5,5 100.000 90.000 Makam

80.000 Monetary loans 5 70.000 Banks' deposits

60.000 Deposit auctions 4,5 50.000 Reserves

40.000 4 30.000

20.000 3,5 10.000

0 3 01/96 10/96 01/97 10/97 01/98 10/98 04/96 07/96 04/97 07/97 04/98 07/98 01… 10… 01… 10… 01… 10… 04… 07… 04… 07… 04… 07…

11 Source: Research Department, Bank of Israel. Policy Debacle: Loss of Credibility

 High monetary interest rate and real interest rate drove inflation to zero despite the higher government-set inflation target  2002: Interest rate reduced by 200 basis points at one time as part of a “package deal”  Credibility undermined – sharp depreciation of the of ER inflation  Interest rates increased sharply

BOI nominal interest rate The ER band & Actual inflation % % 2000-2003 8,5 2000-2003 13 currency basket 10 7,5 2000-2003 8 11 6 9 6,5 4 2 7 5,5 0 5 4,5 -2 3 3,5 -4 0… 0… 0… 0… 01… 01… 01… 01… 01/01 07/01 01/02 01/03 01/00 07/02 07/03 07/00 01/01 07/01 01/02 01/03 01/00 07/02 07/03 07/00 12 Source: Bank of Israel. Achieving Credibility and Anchoring Inflation Within the Target Range: 2005-Onward

 After the debacle of 2002: Monetary policy adheres closely to the inflation target

 Follow a Taylor rule

 The inflation is anchored at the target range since 2005

13 New Bank of Israel Law 2010: From De Facto to De Jure IT

BOI’s Policy Objectives: Maintain price stability, as the central goal (Allow up to 24 months to correct deviations from target) Support economic policy, primarily growth, employment and reducing social gaps Support the stability and orderly activity of the financial system  Independence in the use of policy tools  Monetary Policy Committee – 3 internal members and 3 external members

14 The Road to Price Stability

% Inflation rate and inflation targets 25 (1990-2016, annual rate, percent)

20

15

10

5

0

-5 01/11 01/91 01/12 01/13 01/14 01/15 01/16 01/01 01/10 01/92 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/90 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/00

15 Source: Research Department, Bank of Israel. Inflation, Inflation Expectations, and the Key Rate (1990-2016, annual rate, percent)

% 25

20

15

BOI 10 interest rate Inflation 5 Expected inflation 0

-5 01/11 01/91 01/12 01/13 01/14 01/15 01/16 01/01 01/10 01/92 01/93 01/94 01/95 01/96 01/97 01/98 01/99 01/90 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/00

16 Source: Research Department, Bank of Israel. Credibility of Monetary Policy Achieved by 2005

10-year breakeven inflation expectations % (Israel, 2001-2016) 7

6

5

4

3

2

1

0 05/11 01/12 01/14 01/10 09/12 05/13 09/14 05/01 01/02 01/04 01/06 01/08 09/10 09/02 05/03 09/04 05/05 09/06 05/07 09/08 05/09

17 Source: Research Department, Bank of Israel. Indexation of Rent Contracts in US$

% The percentage of rents indexed 100 to US$ 1990-2014 90 80 70 60 50 40 30 20 10 0

*Data until 2004– assumes 90% indexation 18 Source: Bank of Israel, Israeli Central Bureau of Statistics. Lessons From Israel’s Experience Achieving the Inflation Target

During Disinflation:

Focus on inflation (rather than output gap): React aggressively to upward deviations from target

Real interest rate is very effective in achieving the inflation target

Institutional arrangements of indexation

20 prolong the disinflation process Unemployment Increased During Sharp Disinflation Periods

Unemployment rate % 16 (1980-2013, annual, percent)

14

12

10

8

6

4

2

0 1981 1991 2011 1982 1983 1984 1985 1986 1987 1988 1989 1992 1993 1994 1995 1996 1997 1998 1999 1980 1990 2012 2013 2001 2010 2002 2003 2004 2005 2006 2007 2008 2009 2000

21 Source: Bank of Israel, Israeli Central Bureau of Statistics. Implementing Monetary Policy

Use of interest rate policy is dependent on the ability of the central bank rate to affect monetary aggregates

In countries with underdeveloped banking systems – use of repo is limited

Central bank can issue central bank bonds

Central bank can operate by offering deposit facilities to banks

22 Implementing Monetary Policy (continued)

In disinflation stage – fear of floating, as risk of sharp exchange rate depreciation is significant

Instead of Taylor rule, provide the central bank with an exchange rate target (band) that is consistent with the inflation target and requires the use of interest rate policy

Therefore, managed floats are used – leading to buildup of FX reserves and the need for sterilization

23 BOI Balance Sheet: Assets and Liabilities (NIS million, annual, 1990-2014)

NIS million FX reserves 40.000 Assets 30.000 Governmen t bonds 20.000 Monetary 10.000 loans 0 Other

15.000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Monetary base

-5.000 BOI bonds

Bank deposits -25.000 FX liabilities Liabilities -45.000

24 Source: Bank of Israel. The Final Stage of Inflation Targeting – Anchoring Long-Term Inflation Expectations

Ability to issue long term nominal government bonds

Anchoring is achieved when long-term inflation expectations are anchored around the target

Expectations derived from breakeven inflation when nominal government bonds are introduced in conjunction with existing indexed bonds

Free float is possible as short terms fluctuations in exchange rate do not undermine price stability

25 Disinflation Allowed Government to Issue Nominal Debt and Longer Maturities

Market share of government bonds by indexation type – 1992-2013 100% 90% Nominal 80% 70% Indexed to 60% foreign 50% currency 40% 30% Indexed to CPI 20% 10% 0% 1997 2011 1992 1993 1994 1995 1996 1998 1999 2012 2013 2001 2010 2002 2003 2004 2005 2006 2007 2008 2009 2000

26 Source: Bank of Israel, Israeli CBS. The Final Stage of Inflation Targeting – Anchoring of Long Term Inflation Expectations

Flexible inflation targeting – allows for temporary deviations from IT and targeting output gap

Use forward looking policy – “ahead of the curve”

Incorporating expectations about activity abroad 27 Anchoring of the Long Term Nominal Yields

% Ten-year bond yields for selected 7 inflation targeters (2008 – 2016) Poland 6 US 5 Canada

4 Australia Israel 3 New Zealand 2 Korea Norway 1 07… 07… 07… 07… 07… 07… 07… 07… 01/… 01/… Sweden 01/11 07/11 01/12 01/13 01/14 01/15 01/16 01/10 28 Source: Bank of Israel and Bloomberg. Short Term Interest Rate Policy Flexibility

% 9 Interest rate for selected inflation targeters (2008 – 2016, monthly average) 8 New Zealand 7 Australia 6 Poland 5 Korea 4 Norway 3 Canada 2 Israel 1 Sweden US 0 07… 07… 07… 07… 07… 07… 07… 07… 01/… 01/… 01/11 07/11 01/12 01/13 01/14 01/15 01/16 01/10 29 Source: Bank of Israel and Bloomberg. Conclusions:

 Initial stages of inflation targeting Focus on inflation Be aggressive  If necessary, enhance tools by issuing central bank bonds  If managed float is chosen – sterilize  Loosen stance only after long term expectations are anchored  Use forward looking and outward looking Taylor rule

30 Thank You

31 Bank of Israel Policy Tools 2007-2016

5 Bond “The Monetary Committee assesses that monetary policy 4 Purchases 18 Billion NIS will remain accommodative Interest 3 for a considerable time” 2 Rate 1 0,1 (%) 0 01/07 06/07 11/07 04/08 09/08 02/09 07/09 12/09 05/10 10/10 03/11 08/11 01/12 06/12 11/12 04/13 09/13 02/14 07/14 12/14 05/15 10/15 03/16

Intervention Natural Gas Purchase program 3.000 Building reserves 2.500 + Intervention 2.000 FX 1.500 Intervention 1.000 500

(US$) 0 01/07 06/07 11/07 04/08 09/08 02/09 07/09 12/09 05/10 10/10 03/11 08/11 01/12 06/12 11/12 04/13 09/13 02/14 07/14 12/14 05/15 10/15 03/16

Higher Additional Higher PTI capital Variable provision LTV capital limit and Higher requireme Interest for high LTV limit requirements capital capital nts for Rate loans for high LTV requirem requirements high LTV limit Macroprudential ent 03/23 Measures10/9507/09 06/6802/82 01/4110/54 09/1305/27 01/00 01/07 06/07 11/07 04/08 09/08 02/09 07/09 12/09 05/10 10/10 03/11 08/11 01/12 06/12 11/12 04/13 09/13 02/14 07/14 12/14 05/15 10/15 03/16

32 Source: Bank of Israel