Monetary Policy Issues in Israel Stanley Fischer Bank of Israel Prepared for Presentation at the Research Conference of the Central Bank of Chile, November 15-16 2007 1

Economic Performance 2

Growth Rate of GDP 2000-2007 % BI- Forecast 3

Budget Deficit* (percentage of GDP, 2000-2007) % Under the assumption that the budget is fully performed 4 *Percent of GDP; excluding credit extended. Until 1996, domestic deficit; from 1997, total deficit. *The data from 2000 refer to the deficit excluding the Bank of Israel’s profits.

Public Sector Debt, Percentage of GDP, 2000-2007 (year-end) % 5

Rate of Inflation in Last 12 Months and Inflation Targets, 1992-2007 % 6

Bank of Israel Interest Rate, Inflation Expectations Bank of Israel Interest Rate, Inflation Expectations*, and the Fed’s interest Rate, 2004-2007 % 7 *For 12 months, as derived from the capital market.

The Nominal and the Real Exchange Rate 2007 - 1997 NIS Shekel / Dollar Exchange Rate The Real Exchange Rate by Trading Partners (100=01/1997, 01/1997-11/2007) 127.6 A rise in the index indicates depreciation. The figure for November 2007 is calculated from spot exchange rates known for the half-month, our forecast CPI from the monthly model, and an extrapolation of inflation in the countries whose currencies are in the currency basket. SOURCE: IFS data. For April to November 2007, Bank of Israel calculations. 8 *The Nis/$ chart is on a daily basis, while the real exchange rate chart is on a monthly basis.

Openness of the Israeli Economy (percentage of GDP, 1995-2007*) % *First half of 2007. *Goods and Services. 9 Source: National accounts, CBS.

Current Account of Balance of Payments as Percentage of GDP, 1995-2007 Current Account of Balance of Payments as Percentage of GDP, 1995-2007* (Annual) * First half of 2007. * Foreign Currency Department forecast 10 SOURCE: Balance of Payments, Central Bureau of Statistics.

Non-Monetary Policy Issues 11

Non Monetary Policy Issues: Bank supervision Labor dispute Reorganization New law Economic advisor to the government 12

Monetary Policy Issues 13

Volatility of Inflation and the Exchange Rate, 1997.1-2007.7 USA UK Mexico Chile Brazil Israel 0.90% 0.72% 2.25% 1.13% 3.60% 2.68% Inflationa 2.33%c 2.01% 1.66% 2.30% 3.76% 1.76% Exchange Rateb a SD of 12 months inflation. b SD of monthly depreciation against the US$. C US$ against synthetic €. 14

Responses to FX and to Monetary Shocks 15

Impulse Response to an FX Shock Quarterly model of BoI Monetary Department * Shock of 1 percentage point. * Immediate pass-through to inflation is about one third (FX-level, Inflation-annualized!). * Complete (though gradual) pass-through. SOURCE: Bank of Israel – Monetary department. 16

Impulse Response to an Interest Rate Shock Quarterly model of BoI Monetary Department 17 * Shock of 1 percentage point. SOURCE: Bank of Israel – Monetary department.

Impulse Response to an FX Shock VAR(2) * Cholesky Ordering: Output gap, depreciation, inflation and interest. * Interest rate is de-trended by the path of inflation target (making it stationary during the disinflation period). * Output gap = actual – potential (percentage difference) ; using the production function approach (estimated by the research dep.). * VAR (1) ; in order to be consistent with the theoretical models presented in the previous slides. SOURCE: Bank of Israel – Monetary and Research departments. 18

Impulse Response to an Interest Rate Shock (VAR(2)) * Cholesky Ordering: Output gap, depreciation, inflation and interest. * Interest rate is de-trended by the path of inflation target (making it stationary during the disinflation period). * Output gap = actual – potential (percentage difference) ; using the production function approach (estimated by the research dep.). * VAR (1) ; in order to be consistent with the theoretical models presented in the previous slides. 19 SOURCE: Bank of Israel – Monetary and Research departments.

Dealing with Inflation Volatility: Core inflation or local price inflation Remove only housing from headline Inflation Change the law Let nature and good performance do their work 20

The Exchange Rate: Frequent pressures for intervention Stronger shekel or weaker dollar – setting out the facts Fiscal policy Does the interest rate react to the exchange rate? 21

Asset Prices: Not our issue so far Responsibility for financial stability What to do in the case of irrational exuberance? 22

Interest Rate Smoothing: Why? Publishing: Inflation forecasts Interest Rate forecasts Biases, hints about future decisions 23

Interest Rate Policy: The Taylor Rule 24

The Estimated Equation Variables: Operators: CPI Inflation. Expectations. BoI interest rate. Inflation target (Average of next 12 months). Output gap. Difference. 1). General comments: ******************** 1.1. The BoI interest rate is de-trended (using the inflation target) for the sake of stationarity (Admittedly, not so helpful). 1.2. Regarding the time indices – recall that decisions are taken in the preceding month. 2). Operational definitions of the variables: ******************************************** 2.1. Natural real interest rate – Implied forward real interest rate (3 to 8 years ahead). 2.2. Output gap – Seasonal adjusted gaps from HP trend of Melnik index (neither the NAIRU approach, nor gap of growth from “natural” real interest rate proved successful). 2.3. Real exchange rate – price of imported goods over the CPI (fruits & veg excluded). 2.4. Real exchange rate gap – Seasonal adjusted gaps from HP trend (neither rate of change nor deviations from PPP proved successful). Nominal FX w.r.t. the US$. 25

Estimated Policy Rule of BoI 1999.01-2007.09 ; monthly frequency Notes: 1. OLS estimation. No endogenity bias, since decisions are taken in the preceding month (Thus, the lagging repressors are uncorrelated with the unexpected residual). 2. Null hypothesis – of no structural change in 2005.6 – is not rejected by Chow breakpoint test. However, from 2005.6 onward (under the present governor), only the smoothing parameter and the expectations coefficient are significant. 26 * Estimation accounts for AR(1) process of the residuals.

The Estimated Equation Ilek Alex (2006) Variables: Operators: CPI Inflation. Expectations. BoI interest rate. “Natural” real rate of interest. Output gap. Difference. 1). General comments: ******************** 1.1. The BoI interest rate is de-trended (using the inflation target) for the sake of stationarity (Admittedly, not so helpful). 1.2. Regarding the time indices – recall that decisions are taken in the preceding month. 2). Operational definitions of the variables: ******************************************** 2.1. Natural real interest rate – Implied forward real interest rate (3 to 8 years ahead). 2.2. Output gap – Seasonal adjusted gaps from HP trend of Melnik index (neither the NAIRU approach, nor gap of growth from “natural” real interest rate proved successful). 2.3. Real exchange rate – price of imported goods over the CPI (fruits & veg excluded). 2.4. Real exchange rate gap – Seasonal adjusted gaps from HP trend (neither rate of change nor deviations from PPP proved successful). Inflation target (Average of next 12 months). Nominal FX w.r.t. the US$. 27

Estimated Policy Rule of BoI 1997.10-2006.04 ; monthly frequency ; Ilek (2006) Notes: 1. OLS estimation. No endogenity bias, since decisions are taken in the preceding month (Thus, the lagging repressors are uncorrelated with the unexpected residual). 2. Null hypothesis – of no structural change in 2005.6 – is not rejected by Chow breakpoint test. However, from 2005.6 onward (under the present governor), only the smoothing parameter and the expectations coefficient are significant. 28

Thank you 29