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

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The Long Journey from High Inflation to Price Stability: the Case of Israel 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 2 200% 300% 400% 500% 250% 350% 450% 100% 150% -50% 50% 0% Source: Bank Israel.of 1954 1957 Israel of the Bank of Establishment the Since Inflation 1960 Acceleration 1963 2015 Actual inflation (12-month) 1954 - 1966 1969 1972 1975 1978 Disinflation Stabilization 1981 1984 1987 1990 1993 1996 1999 2002 PriceStability 2005 2008 2011 2014 “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 5 10 15 20 25 -5 0 5 1986 Source: Bank Israelof 1987 1988 1989 From “Price toward Stability” “Disinflation” 1990 1991 Actual inflation (12-month) Actual(12-month) inflation 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2016 1986 - 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 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 10 10 12 14 0 2 4 6 8 Source: ResearchDepartment, Bank of Israel. 01/96 03/96 Real BOI rate interest 05/96 07/96 percent) rate, (Annual Monetary Policy,Monetary 1996-1998 and PriceAchievedDisinflation Stability by Tight 09/96 11/96 01/97 03/97 05/97 07/97 09/97 Ex Post 11/97 01/98 03/98 05/98 07/98 09/98 11/98 10 12 14 0 2 4 6 8 01/96 03/96 05/96 07/96 Actual inflation 09/96 11/96 (12-month) 01/97 03/97 05/97 07/97 09/97 11/97 01/98 03/98 05/98 07/98 09/98 11/98 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 15 20 25 10 15 -5 0 5 % Source: ResearchDepartment, Bank of Israel. 01/90 01/91 01/92 The The Road to Price Stability 01/93 01/94 01/95 Inflation rate and inflation targets and inflation rate Inflation 01/96 (1990-2016, annual rate, annual (1990-2016, percent) rate, 01/97 01/98 01/99 01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11 01/12 01/13 01/14 01/15 01/16 20 25 16 10 15 -5 0 5 % Source: ResearchDepartment, Bank of Israel. 01/90 01/91 01/92 Inflation, Inflation Expectations, and the the and Expectations, Inflation Inflation, (1990-2016, annual rate, annual (1990-2016, percent) rate, Expected Expected 01/93 inflation 01/94 01/95 01/96 01/97 01/98 01/99 01/00 01/01 01/02 01/03 interest 01/04 rate BOI 01/05 01/06 01/07 01/08 Inflation 01/09 01/10 01/11 01/12 01/13 Key Rate Key 01/14 01/15 01/16 17 0 2 3 4 5 6 7 1 % 05/01 Source: ResearchDepartment, Israel. Bank of 01/02 09/02 2005 Policy Achieved Monetary by of Credibility 10-year breakeven 10-year expectations inflation 05/03 01/04 09/04 05/05 2001-2016) (Israel, 01/06 09/06 05/07 01/08 09/08 05/09 01/10 09/10 05/11 01/12 09/12 05/13 01/14 09/14 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 10 12 14 16 21 0 2 4 6 8 % Source: Bank Israel,of IsraeliCentral ofBureau Statistics. 1980 1981 1982 1983 PeriodsDisinflation Sharp During Increased Unemployment 1984 1985 1986 1987 percent) annual, (1980-2013, 1988 1989 1990 rate Unemployment 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 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.
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