Almost twenty years have gone by since Israel's annual inflation target range was set at 1-3%. The Bank of Israel is now considering changing the target. Last week, the bank invited the public to express its opinion on the matter. If it comes to the conclusion that there is room for changing the current target, the Bank of Israel will recommend the government to act accordingly.
The Bank of Israel's first task is to maintain price stability in the Israeli economy, using the interest rate tool among other things. The price stability goal is expressed as a target range for the annual inflation rate. The target is set by the government in consultation with the Governor of the Bank of Israel.
Last month, the annual rate of inflation reached 2.8%, close to the upper limit of the current target range. In normal times, if you were to ask the central bank, it would say that inflation is not necessarily a bad thing — on the contrary. Nevertheless, there is a fear of loss of control that could lead to the central bank being dragged along after the market.
The Bank of Israel is not forecasting an interest rate rise, even in the event that inflation exceeds the target range, on the basis of the assumption that the inflation rate will return to the middle of the range this year. The Bank of Israel boasts of the luxury of low inflation in comparison with other countries.
Why change the target?
The inflation target affects inflation expectations, and thereby influences monetary policy. Suppose that the inflation target in Israel was 2%, and not a 1-3% range, and suppose that this target was rigid and not flexible, then the Bank of Israel would have to raise interest rates, otherwise inflation would exceed the target. In practice, in the past few years, the dilemma has been the other way. Until not long ago, before the outbreak of the coronavirus pandemic, inflation was below the target range, which supported monetary expansion, which in turn led to a steep rise in real estate prices.
Why change the target now?
It's hard to ignore the fact that inflation now threatens to exceed the inflation target range, and the expectation on the financial markets is that the Bank of Israel will raise its interest rate this April. Re-examining the inflation target represents an attempt to create more flexibility for raising the interest rate in relation to the rate of price rises in the economy. The Bank of Israel explains, however, that the process started at a time when the inflation rate was fairly low, and that the decisions that will eventually be made will not be affected by short-term inflation.
Does the target guide inflation or does inflation guide the target?
Last year, the European Central Bank changed its inflation target from "below, but close to, 2%" over the medium term, to 2% over the medium term (a symmetric target). The US Federal Reserve replaced its 2% inflation target with a commitment "to achieve inflation that averages 2% over time." The Federal Reserve did not imagine that reality would flip so rapidly, that inflation would soar to 7.5%, and that the average target would become so problematic. Perhaps the Bank of Israel realized that the Federal Reserve had made a mistake and that it may have had political motives.
What about the cost of living?
According to Bank Hapoalim chief economist Victor Bahar, inflation has become more volatile, and there is a growing sense that the Consumer Price Index does not by itself reflect price changes as a whole. There is therefore an advantage in setting an inflation target with a wide range, without setting out to hit a particular number (a symmetric target), and certainly without any averaging over time as in the US.
"In the past few years we have seen Europe switch to a symmetric target and the US switch to a target average," Bahar explains. "In my view, applying the outcome test, these targets harm the credibility of an inflation target. That's particularly the case in the US. To balance out inflation of 7.5% would take years of zero inflation, and it's pretty clear that the Fed Is not aiming at that. A symmetric target that lets bygones be bygones is also problematic, and we are seeing that the ECB is not currently acting with determination to reduce inflation to 2%. A target that is a range allows greater flexibility and consideration of factors such as asset prices and financial markets."
Bahar says that central banks don't like an inflation target that starts from zero, because of a longstanding perception that inflation measurement is skewed upwards. "Zero inflation is perceived as a risk, among other things because of the view that technological improvements do not find suitable expression in the inflation index, and that there is an upward bias in the measurement," he explains. "In today's reality, we can name several factors that skew the index downwards, and the gap between the public's perceptions and the official inflation figure is wide — not something unique to Israel. There are many measurement difficulties in a world of frequent technological change, and so in my opinion the inflation target should start from zero."
Why has the Bank of Israel called for public consultation?
In the past, the Bank of Israel has canvassed public opinion on payments by mobile telephone, the clearing infrastructure, and issuing a digital currency, and now it is doing so for the inflation target. Market analysts say that this is an accepted process, and research departments at investment houses and researchers at the universities are given an opportunity to have their say on the matter.