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

2. Economic Performance 2

3. Growth Rate of GDP %
BI- Forecast 3

4. 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.

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

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

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

8. 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/ /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.

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

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

11. Non-Monetary Policy Issues11

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

13. Monetary Policy Issues13

14. 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

15. Responses to FX and to Monetary Shocks15

16. 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

17. 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.

18. 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

19. 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.

20. 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

21. 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

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

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

24. Interest Rate Policy:
The Taylor Rule 24

25. 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

26. Estimated Policy Rule of BoI
; 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 – is not rejected by Chow breakpoint test. However, from 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.

27. 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

28. Estimated Policy Rule of BoI
; 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 – is not rejected by Chow breakpoint test. However, from onward (under the present governor), only the smoothing parameter and the expectations coefficient are significant. 28

29. Thank you 29