The Rules of Disengagement

There are unambiguous rules of disengagement from the deflationary territory. Israel's short-term interest rates are extraordinarily low, but the economy would definitely benefit from a more accommodative monetary stance, in our opinion. The consumer price index, for example, increased by a cumulative rate of a mere 0.1% in the first four months of this year, following a 0.2% decline in the second half of last year. Consequently, consumer prices were up by 0.3% in the twelve months to April, down from 1.2% at the end of last year, despite a surge in oil and other commodity prices. According to our projections, the annual inflation rate will barely exceed the lower bound of the central bank's yearend target range of 1 to 3% this year. In other words, the Israeli economy will continue to struggle with deflationary pressures, not the menace of inflation. This is why we have argued that the Bank of Israel should follow the unambiguous rules of disengagement from the deflationary territory and lower short-term interest rates by 25 basis points to 3.25% at the end of this month.

Globalisation and the slow pace of recovery in domestic demand drive consumer prices. The producer price index posted a month-on-month increase of 1.7% in April that kept the twelve-month inflation rate at 6.3%, following an average of 6.5% in the first quarter of this year and 5.4% i2004. Even though the rise in energy and industrial commodity prices in the last two years is behind this divergence' in producer prices, the pass-though to consumer prices has been remarkably very low. In our opinion, there are three key reasons contributing to this curious phenomenon. First, Israel's open economy has benefited from globalisation driving both production costs and profit margins lower all around the world. Second, despite a robust turnaround in economic activity last year, the slow pace of recovery in final domestic demand keeps inflationary pressures at bay. Third, Israel still has a substantial output gap that, coupled with productivity improvements, limits the rise in unit labour costs. As a result, our calculations show that consumer prices actually declined by 0.2% on a seasonally adjusted basis in April. That figure implies not a threat of inflation on the horizon but a deflationary reading of 1.1% over three months (down from an average increase of 1.0% last year and 1.7% in the 2000-2003 period).

The recent drop in global commodity prices may push the inflation rate even lower. We are likely to see an increase in the consumer price index in the next couple of months, due largely to seasonal factors and base effects, but the underlying trend clearly shows that Israel's dance with deflation is not going to end in the near future. In fact, the slowdown in global economic activity and the resulting drop in commodity prices may reinforce deflationary pressures. For instance, the CRB industrial commodities index declined by 6.6% month-on-month in May (and by 14.0% from its peak in last year). Not surprisingly, Israel's wholesale price index excluding energy prices posted a year-on-year increase of just 3.8% in April, following an average increase of 4.8% in the first quarter and 4.3% last year. Moreover, contrary to the consensus view, we believe that the shekel is still undervalued against both the dollar and the euro and that even a narrower interest rate differential vis--vis the US would not lead to a dangerous depreciation-to-inflation spiral.

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Israel's dependence on external trade makes it vulnerable to a global slowdown. The growth rate of the country's real gross domestic product decelerated from 4.4% in the last quarter of 2004 to 2.9% in the first quarter of this year. Since then, the state-of-the-economy index recorded a seasonally adjusted month-on-month drop of 0.2% in April. The year-on-year change in this composite gauge of real economic activity in Israel moved from an increase of 4.6% last year to 3.1% in the first quarter and just 1.7% in April. In our view, the economy, following global trends, is slowing from a real growth rate of 4.3% in 2004 towards our projection of 3.8%, or even less, this year. Exports, excluding diamonds, increased by 8.7% in the first four months of this year, down from a growth rate of 21.6% last year. More distressingly, high-technology sectors recorded a cumulative export growth of 5.9%, after enjoying a 21.7% increase in 2004. Although we think that Israeli firms will continue to have the benefit of a competitive stance in the global marketplace, the country's dependence on external trade makes it vulnerable to an unexpectedly sharp global slowdown.

The drop in the unemployment rate reflects the past, not the future, in our view. The seasonally adjusted unemployment rate declined from 9.8% in the last quarter of 2004 to 9.1% in the first quarter of this year. Although this is the lowest reading in the last four years, the most recent employment survey shows an on-going weakness in the labour market and reflects the past improvement rather than the future. In our view, further, significant improvements in the jobless rate are unlikely, given the country's labourforce participation rate, which stands at 54.7% of the population, is likely to increase on the back of structural reforms. In addition, though not directly comparable to the employment survey, the number of unemployment claims increased by 1.9% month on month on a seasonally adjusted basis in April, and the average (gross) salary in declined by 1.3% year on year in real terms. Consequently, the real increase in private consumption in the first quarter was down to an annualised rate of 0.8%, from a pent-up demand-driven 12.4% in the final quarter of last year. Moreover, the latest figures on imports of capital goods confirm the marked deterioration in business investment spending that already declined by 10.4% in the first quarter.

Fiscal consolidation is still the key to economic rejuvenation. The government budget posted an overall surplus of 14 million shekels in May, resulting in a cumulative surplus of 3.1 billion shekels in the first five months of this year. Of course, seasonal factors and the delayed introduction of the 2005 budget played a role in restraining budgetary spending so far this year, our calculations suggest that the year-end figure will remain within the target of 3.4% of GDP, down from 3.9% last year. Such fiscal consolidation has had expansionary effects on the economy by lowering Israel's tax burden from 40.1% of GDP in 2001 to 38.5% in 2003 and 38.2% last year.

Nevertheless, the current level remains distortionary for the corporate sector and, more importantly, for low-income groups. This is why we support the Ministry of Finance's efforts to lower the tax burden on average wage earners by 11.3 billion shekels over the course of next five years,