Israeli Inflation From An International Perspective

Contributor Notes

Author’s E-Mail Address: Dorsmond@imf.org; sfischer@imf.org

Israel’s post-stabilization experience of moderate inflation and eventual disinflation is compared with experiences in other countries. Lessons that emerge from an examination of international experiences indicate the importance of establishing early on credibility in the nominal anchor and a commitment to persevere with disinflation policies, achieving and maintaining a tight fiscal position, measures to reduce nominal rigidities, and widespread structural reform. Israel falls short on several criteria which explains why taming inflation in the post-stabilization period has been difficult. The paper concludes with a consideration of institutional arrangements that could sustain the current low inflation levels.

Abstract

Israel’s post-stabilization experience of moderate inflation and eventual disinflation is compared with experiences in other countries. Lessons that emerge from an examination of international experiences indicate the importance of establishing early on credibility in the nominal anchor and a commitment to persevere with disinflation policies, achieving and maintaining a tight fiscal position, measures to reduce nominal rigidities, and widespread structural reform. Israel falls short on several criteria which explains why taming inflation in the post-stabilization period has been difficult. The paper concludes with a consideration of institutional arrangements that could sustain the current low inflation levels.

I. Introduction

In its 50 year history, Israel has undergone almost the full range of inflation experiences, including periods of low inflation in the 1950s and 1960s, double digit inflation in the 1970s, triple digit inflation through the mid-1980s, back to a prolonged period of moderate double digit inflation after the 1985 stabilization program, then finally recently achieving low single digit levels. The only missing experiences are those of deflation and genuine hyperinflation, although the high inflation of the mid-1980s is often described as a hyperinflation.

The Israeli inflationary experience and its successful 1985 stabilization program have been extensively compared with the experiences of other countries (see for example Bruno, et al, 1988, 1991; Bruno, 1993). The main focus of this paper is on the post-stabilization period. In particular, we compare Israel’s experience of moderate inflation and eventual disinflation with those of other countries, to draw conclusions for both Israeli policy and the disinflation process in general.

The paper is organized as follows. In Section II we provide a brief overview of Israel’s long-term inflation history. This sets the context for the description in Section III of Israel’s struggle during the post-stabilization period to disinflate from moderate to low single digit levels. In Section IV we summarize lessons on the disinflation process that have emerged from experiences in other countries, which are drawn in reference to nine countries, three of which moved from high to low inflation levels without an intervening period of moderate inflation, four which experienced moderate inflation for a period and then lowered inflation to single digit levels, and two which were for a long time stuck with moderate inflation. Drawing on these general lessons, we analyze in Section V why it proved so difficult to tame inflation in Israel. In the final section we address institutional issues that will help determine whether Israel is able to sustain the current low inflation levels.

II. Rising Inflation Pressures and Stabilization, 1951–85

Figure 1 plots (on a logarithmic scale) the inflation rate2 in Israel during the last half-century. After rising briefly in the early 1950s to a peak of 60 percent per annum as previously controlled prices were deregulated and the exchange rate was devalued, inflation remained below 10 percent for virtually the entire period until the 1970s. This was the period of Israel’s miracle economic growth, which averaged 10 percent per annum until 1965 when, in the face of an increasing external deficit and rising inflation, policy turned sharply contractionary and a recession began that reduced inflation to close to zero and raised the unemployment rate to more than 10 percent.

Figure 1.
Figure 1.

Israeli inflation, 1951-99

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

The restrictive fiscal and monetary policies were reversed at the end of 1966. Although the Six-Day War resulted in a large increase in government spending,3 it also in effect increased the labor force, as Palestinians began to be employed in Israel, and inflation, although rising, continued low through the end of the 1960s. Growth too returned to the former miracle rates. The pace of inflation then rose rapidly, first to double digit levels in the early 1970s as expansionary policies continued, to annual rates that averaged 35 percent in 1974–77, then to rates around 125 percent in 1980–83, and finally to annual rates that peaked at over 450 percent in 1984–85.

The initial rise in inflation to levels that were more than 30 percent per annum was linked to the sudden slowdown in annual growth to just 3 percent, itself a function of the first oil price shock in 1973, the Yom Kippur War (after which military expenditure increased by 10 percent of GDP, partly financed by increased foreign aid), the failure to adjust other fiscal expenditures to reflect the slower pace of growth and hence of revenues, and the rapid growth in real wages even as total productivity in the business sector declined. Inflation then accelerated after 1977 as the nominal anchors in the economy were weakened with the introduction of a real exchange rate rule, liquid foreign exchange (PATAM) accounts which decreased the demand for shekel-denominated assets, and other policies that limited the Bank of Israel’s (BoI) control over the monetary base.4 In response, efforts to reduce inflationary pressures were either pursued for too short a period (nine months in 1979), or focused on price and wage controls rather than on a lasting fiscal retrenchment (1982–83), an approach that provided at best a brief respite.

The famous mid-1985 stabilization program represented a comprehensive attack on the root causes of high inflation in Israel. It was based on the following components:

  • The high fiscal deficit—which had been at the core of both the excess demand conditions for nearly 20 years and of the rising public debt level—was substantially reduced through a cut in subsidies for basic foods, transport, and export credits, reductions in defense spending, the imposition of new taxes including a temporary surcharge on self-employed income, and increased foreign aid.5 The fiscal deficit fell from 13 percent of GDP in 1984, to less than half that level in the second half of 1985, and the budget was in surplus by 1986.

  • The effectiveness of monetary policy was enhanced: the Bank of Israel (BoI) restricted the growth of credit by raising reserve requirements and the real discount rate on deregulated bank lending; the minimum term for dollar-indexed (PATAM) deposits was raised to one year; a new central bank law in 1986 forbade borrowing from the BoI to finance the budget except for bridging loans within the fiscal year; and the tradability of government bonds was improved.

  • The exchange rate was devalued by 25 percent at the start of the program, and partially unified for exporters and importers. To anchor price expectations, the rate was fixed to the U.S. dollar at NIS 1.5 per dollar, conditional on maintaining an “appropriate” level of wages.

  • Backed by the solid adjustment in the macroeconomic fundamentals, an incomes policy was used to reduce inflationary inertia. Backward-looking wage indexation was temporarily suspended, replaced with a flat increase in nominal wages by 14 percent in August and 12 percent in September designed to compensate for the initial devaluation and inflation, with further wage increases delayed until December. The prices of virtually all (90 percent) goods and services were frozen for three months after an initial 17 percent increase. The extensive indexation of financial assets was not altered.6

  • The credibility of the stabilization program was enhanced by large-scale U.S. financial aid to help finance the fiscal deficit and guarantee balance of payments viability ($ 1.5 billion over two years, or over 3 percent of GDP per year), and by the withdrawal from Lebanon in the same month the Knesset voted on the stabilization package. Patinkin (1993) argues that the withdrawal from Lebanon increased the government’s policy credibility by showing its ability to deliver on controversial policies.

As a result of these aspects, the 12-month inflation rate fell quickly from 450 percent in mid-1985 to 20 percent by the start of 1986. Indeed, Israel’s stabilization program remains one of the most successful on record.

III. Israel’s Experience with Moderate Inflation, 1986–2000

There have been three distinct inflation periods in Israel since the stabilization program in 1985: the first from 1986–91 when annual inflation was around 15–20 percent, the second from 1992 to mid-1997 when annual inflation hovered around 10 percent, and the third from mid-1997 onwards, when inflation fell rapidly to recent levels around 2 percent although there was a temporary spike in inflation at end-1998 due to the effect on the price level of the large depreciation. Economic indicators for the post-stabilization period are shown in Table 1 and Figures 23.

Figure 2a.
Figure 2a.

Israel: Overall and Underlying Inflation 1/, 1986-99

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

Source: Bank of Israel.1/Excludes housing, fresh fruits and vegetables.
Figure 2b.
Figure 2b.

Israel: Tradable, Nontradable, and Wage Inflation, 1986-99

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

Source: Bank of Israel.
Figure 3.
Figure 3.

Macroeconomic Indicators: Israel, 1985-2000

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

Table 1.

Israel: Economic Indicators, 1980-99

(in percent unless otherwise noted)

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Source: IMF, International Financial Statistics, Bank of Israel, Annual Report 1999, and authors calculations.

Operational general government deficit as reported m Bank of Israel, Annual Report.

Excludes housing and fresh fruit and vegetables. All inflation data are end period.

Nominal discount rate annualized, then deflated by overall cx post CPI. Data are similar if the BoI’s price expectations series is used (this series is only available after 1989).

Real rate of return on net capital.

Defined in terms of local currency to that of trading partners. An increase is an appreciation. Index 1995=100.

Civilian imports and exports, excluding capital services and diamonds. Index 1995=100.

The discussion in this section and later in the paper is informed by the results of empirical work on the interactions of changes in the money stock, interest rates, exchange rates, output and inflation in Israel during the post-stabilization period, which is summarized in Appendix I.7 Briefly, the Appendix indicates that restrictive monetary policy does reduce inflation and output levels. Further, while there is a short-run inverse relationship between output and inflation, there does not appear to be a long run relationship.

A. The Initial Post-Stabilization Inflation Plateau, 1986–91

Re-inflationary pressures were evident after mid-1986. In large part, these were caused by the nominal and real wage increases conceded in the early phases of the program and their accommodation by monetary policy, which was looser than originally envisioned as credit growth exceeded its target. While real interest rates were initially high in the deregulated segment of bank borrowing—6–7 percent per month in mid-1986—this segment constituted only a small share of total credit and real rates were much lower for the large directed credit segment. By end-1986, real rates in the deregulated lending segment had fallen to the still excessively high level of 2 percent per month (Leiderman, 1993).

Demand pressures increased as monetary restrictiveness was relaxed. The early success of the stabilization program—increases in foreign reserves and the rapid decline in inflation without an initial output cost—led to the perception that “now was the time to grow,” meaning to relax restrictive policies (Bruno and Piterman, 1988). Reflecting this view, marginal income taxes were reduced and investment incentives were increased, whereupon the domestic fiscal deficit (which abstracts from foreign assistance) deteriorated in each quarter from mid-1986, rising from 1 percent of GDP in 1986 to 4 percent of GDP by 1988. The foreign fiscal deficit also increased after 1986 after the conclusion of the extraordinary U.S. financial assistance.

Demand pressures were sustained by increases in real wages. After contracting by 7 percent in 1985, real business wages increased 9 percent in 1986 and 8 percent in 1987, indeed real business sector wages returned to their pre-stabilization level within 9 months of the start of the program, and public sector wages within 12 months, levels which had been regarded before the stabilization as too high. This increased pressure on nontradable prices—most price controls had been removed by March 1986—and squeezed profitability levels, especially in the tradable sector.8 With the looser-than-envisioned monetary policy, a deteriorating fiscal position, and high real wage growth, there was only a very gradual decline in the rate of increase in underlying nontradable prices after the initial success.9

Tradable goods price increases were tied to the NIS/$ peg. Initially, the decline in the U.S. dollar in the second half of 1985 against other major currencies imparted an inflationary boost to the overall price index—which helped offset the impact on competitiveness of the increase in nominal wages and hence in nontradable prices—but there were important counteracting pressures from the simultaneous decline in world oil prices. After the peg was set in terms of a currency basket in August 1986, competitiveness began to be erode and with it profitability. At the same time, the interaction of the fixed exchange rate with the loose fiscal, monetary and wage policies noted above supported a consumption boom—a common feature in exchange rate based stabilization programs (Calvo and Vegh, 1990, 1991; Leiderman and Bufman, 1992)—which was reflected in a sharply deteriorating current account position. Faced with these pressures, the authorities devalued the currency by 10 percent in January 1987.

In response to the squeeze on profitability and some structural reform in the business sector, inflation pressures began to slow again from mid-1987. Monetary policy was then significantly relaxed, with real interest rates turning negative, and the automatic stabilizers acted to increase the fiscal deficit. At end-1988, the exchange rate was again devalued and the fixed rate regime was replaced with a horizontal band, which was then adjusted four times in a two and a half year period. These adjustments were made in response to speculative flows associated with the ongoing inflation premium vis-à-vis Israel’s trading partners, which ensured that a correction would have to be undertaken, albeit by an unknown magnitude at an unknown time (Box 1 outlines the various exchange rate regimes of the post-stabilization period).

The first phase of the post-stabilization period ended around 1991, as the heavy immigration from the former Soviet Union continued, and as it became clear that the adjustable peg system with a band was not sustainable. The immigration was a major boon to the Israeli economy: its impact on economic performance was enhanced by the market-friendly absorption policies implemented by the government, and especially by the agreement to allow new immigrants to work at below-union scale wages. The immigration thus put downward pressure on business sector wages as unemployment increased (through an increase in the supply of labor) by 4 percentage points to 10½ percent in 1991, and enhanced labor market flexibility; it also added to demand pressures by requiring spending for settlement costs and the housing sector.

By 1991, the 12-month rate of inflation stood at 18 percent, only marginally below the rate achieved five years earlier.

Israel: Exchange Rate Arrangements, 1980–2000

Real exchange rate rule (April 1979–September 1982): Exchange rate adjusted to follow a rough real exchange rate rule against a currency basket.

Tablita (September 1982–October 1983): Monthly exchange rate change limited to 5 percent.

Floating exchange rate (October 1983–July 1985): Floating regime after 23 percent up-front devaluation in October 1983.

Fixed exchange rate (July 1985–December 1988): Fixed rate initially against the U.S. dollar after 25 percent up-front devaluation in late June-early July. Rate set at NIS 1.5 per U.S. dollar. Peg switched to a currency basket instead of the U.S. dollar in August 1986, and a devaluation was undertaken in January 1987 (10 percent).

Horizontal exchange rate band (January 1989–December 1991): Devaluation of 13 percent to a midpoint of NIS 1.95 per currency basket unit, within an exchange band of +/- 3 percent in January 1989. Midpoint and band devalued with a midpoint of NIS 2.07 per currency basket unit in June 1989. Midpoint shifted to NIS 2.19 per currency basket unit with width of the band expanded to +/- 5 percent in March 1990. Midpoint shifted to NIS 2.41 in September 1990, and then to NIS 2.55 in March 1991.

Crawling exchange rate band (December 1991 -present): Initially devaluation of 3 percent with midpoint of 2.63 moving at 9 percent per annum thereafter with a width of +/- 5 percent. Devaluation of 3 percent with midpoint at 2.93 with rate of crawl adjusted to 8 percent per annum in November 1992. Devaluation of 2 percent with midpoint at 3.15 with rate of crawl adjusted to 6 percent per annum in July 1993. Devaluation of 0.8 percent with midpoint at 3.54 with rate of crawl left at 6 percent per annum but width of the band expanded to +/- 7 percent in May 1995. Shift in the depreciated limit by 14 percent with rate of crawl of the depreciated limit left at 6 percent per annum, but rate of crawl of the appreciated limit lowered to 4 percent per annum in July 1997. Rate of crawl of the appreciated limit lowered to 2 percent per annum in August 1998. No changes to the exchange rate regime thereafter.

B. The Second Inflation Plateau, 1992–96

As the exchange rate regime shifted to a crawling peg with a band width of +/- 5 percent, inflation fell to around 10 percent in 1992, and for several years thereafter remained around this level, as a result initially of a decline in the rate of increase of tradable goods prices, and of the supply side effects of lower wage increases. The initial reduction in tradable prices reflected a 6½ percent decline in U.S. dollar import prices in 1991–92 due to the appreciation of the dollar against other major currencies. The continuation of the lower rate of inflation resulted from the ongoing moderation in wages, the easing of housing price pressures as the number of new immigrants started to slow after 1992, and some tightening of monetary and fiscal policies.10

These lower inflation levels were by and large sustained in the period 1993–96. Annual tradable price inflation remained relatively constant at 8 percent, and underlying nontradable inflation at around 10 percent. In contrast, housing and fruit and vegetable prices showed a very high level of volatility.

In part, the consolidation of inflation at lower levels reflected important steps taken in 1991–92 to enhance the credibility and effectiveness of the policy framework. Firstly, the 1991 Budget Deficit Reduction Law aimed to provide some assurance that the expansion in fiscal spending associated with the immigrant inflows was temporary. Under this law, a four year domestic deficit11 retrenchment path was outlined, the targets of which fell from 6 percent of GDP in 1992 to fiscal balance by 1995 (Bufman and Leiderman, 1997; Dahan and Strawczynski, 1997). The actual domestic deficit undershot these targets in both 1992 and 1993.

Secondly, as already noted, in December 1991 the mechanics of the nominal anchor were changed. A forward-looking crawling exchange rate band was introduced, with the rate of crawl based on the projected differential between inflation in Israel and abroad. Gradually, as the width of the band was increased from +/- 5 percent to +/- 7 percent—partly to accommodate capital account liberalization—interest rate policy switched from being used in support of the exchange rate regime to achieving the inflation target itself.12 However, the official inflation targets set for the new monetary regime were not very ambitious (between 7–10 percent during this period) and there was little progress on disinflation. After moderating in 1993, nontradable price pressures accelerated sharply in 1994 in response to a premature easing of monetary policy from mid 1993, a consumption boom as new immigrants were absorbed into the labor force, the confidence imparted by the peace process, and a sharp increase in housing and especially fruit and vegetable prices. In the face of these pressures, rather than being tightened, fiscal policy was eased, including a 16.5 percent increase in public sector wages at end 1994. The domestic deficit subsequently overshot its target (3.2 percent of GDP in 1995 compared to a target of 2.75 percent) and the current account began to deteriorate.

With the inflation target achieving increased operational significance, monetary policy was tightened sharply during the second half of 1994, with a 4.5 percentage point increase in the nominal rate, and nontradable inflation pressures eased in 1995. A premature easing of monetary policy during 1995 and substantial fiscal expansion in 1996 (the domestic deficit was 4.7 percent of GDP compared to a target of 2.5 percent) led to further inflationary pressures and a deterioration in the current account deficit during 1996. Monetary policy was again tightened, and this time it was kept restrictive.

The sharp increase in interest rates implied by the combination of loose fiscal and tight monetary policies, as well as the initiation of the peace process and relatively open capital account, led to heavy capital inflows from early 1995. These inflows resulted from direct and portfolio foreign investment, government borrowing under the U.S. loan guarantee program, as well as foreign currency credit from banks as the business sector perceived the costs of such borrowing would be lower than for borrowing in shekels.13 As the exchange rate appreciated to the lower bound of the band, monetary policy became seriously overburdened: the BoI was required to intervene to defend the band and to sterilize the inflows to protect the inflation target.14 In this environment, while monetary policy was used to offset the rising inflationary pressures caused by demand pressures, and hence consolidated inflation at annual rates around 10 percent, further advances in disinflation proved elusive.

C. Single-Digit Inflation, 1997–2000

At the end of 1996, the government announced a new policy package, including a front-loaded fiscal retrenchment path which aimed to reduce the overall fiscal deficit to 1.5 percent of GDP by 2001, and for the first time set a medium-term inflation target (but not path) for 2001 equal to the average of the OECD countries (operationally taken to be 4.5 percent). Almost immediately thereafter, with the ongoing tight monetary policy and associated low economic growth, actual trends indicated that the 1997 deficit target of 2.8 percent of GDP would be exceeded.

In mid-1997, the new minister of finance announced a fiscal package which in the end proved sufficient to achieve the 1997 deficit target,15 and at the same time the depreciated limit of the exchange rate band was widened significantly. With fiscal and monetary policy now both restrictive, the weak activity level (especially investment) and rising unemployment level, a real appreciation of the shekel, and initiation of some structural reforms which lowered prices (e.g., in the telecommunications sector), inflation pressures moderated rapidly after mid-1997. One year later, the 12-month inflation rate was 4 percent, well below the official target of 7–10 percent. In mid-1998, the 1999 target was set at 4 percent, and there was a sharp decline in nominal interest rates in the wake of the declining inflation trend.

Following the Russian crisis and world contagion in August-September 1998, the shekel depreciated sharply in the second half of 1988 as foreign and domestic agents reassessed the risks associated with their earlier unhedged foreign borrowing.16 The risk of renewed inflationary pressures was met forcefully with a 4 percentage point increase in official interest rates; the ongoing containment of fiscal policy and the impact of the depressed economy on the current account, helped to consolidate this monetary response. The BoI chose not to intervene by selling foreign exchange, relying rather on the interest rate increase and private sector responses to it to reverse the depreciation. The inflation rate rapidly returned to annual levels around 4 percent; output growth remained depressed and unemployment high. In 2000, inflation has fallen sharply to around 1½ percent per annum, undershooting the inflation target range for the year of 3–4 percent.

IV. Lessons from Other Countries’ Experiences with Disinflation, 1985–99

We report here on the conclusions of comparative studies of the disinflation process, particularly for countries that have been stuck for a period with moderate inflation (we draw mainly on Dornbusch and Fischer, 1993, and Burton and Fischer, 1998). To provide a context for the subsequent comparative analysis of Israel’s disinflation experience, we summarize experiences in nine countries: three which moved from high to low inflation levels without a period of moderate inflation (Argentina, Brazil, Croatia), three which experienced moderate inflation for a period and then reduced inflation to low levels (Chile, Egypt, Greece), and three which also experienced a period of moderate inflation and at the time of writing still had inflation levels around 10 percent per annum (Colombia, Hungary, Mexico). The main macroeconomic series for these nine countries are shown in Figures 46. A summary of critical features that affected each countries’ success in reducing inflation is presented in Table 2, and their respective experiences are described in greater detail in Appendix II.

Figure 4.
Figure 4.

Macroeconomic Indicators: Argentina, Brazil, and Croatia, 1985–2000

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

Figure 5.
Figure 5.

Macroeconomic Indicators: Chile, Egypt, and Greece, 1985-2000

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

Figure 6.
Figure 6.

Macroeconomic Indicators: Colombia, Hungary, and Mexico, 1985-2000

Citation: IMF Working Papers 2000, 178; 10.5089/9781451858945.001.A001

Table 2.

Selected countries: Policy and Other Factors in Inflationary process

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The experiences of these nine countries, along with those of others, suggest the following interrelated generalizations:

  • Stabilizing inflation at low single digit levels can take a long time.

After a stabilization program was launched, it typically (but not always) took a considerable time to attain a low level of inflation. Indeed, of the nine countries discussed here, Croatia was the only country that reduced inflation to low single digit levels almost immediately following the start of the stabilization program. Two countries took around two years (Argentina, Brazil), but the others took much longer (on average around five years) to achieve this result, in part due to the lack of forcefulness in their disinflation policies. This result suggests the need for policy makers to be prepared from the outset to persevere with anti-inflation policies if their goal is indeed to achieve and then to sustain a low inflation level.

  • A sustainable fiscal balance is critical to the maintenance of low inflation. Accordingly, fiscal retrenchment is generally necessary to lower demand pressures and ensure the maintenance of low inflation.

The establishment and maintenance of a sound fiscal position is a necessary, though not sufficient, condition to reduce inflation to low levels.17 All countries that managed to tame inflation had either already reduced fiscal imbalances (such as Argentina, Brazil, Chile) or made a major fiscal effort from the outset of the stabilization program (such as Croatia, Egypt). Achieving an initial fiscal adjustment was not, however, by itself sufficient to sustain low inflationary pressures. In some countries the fiscal position was relaxed soon thereafter since structural fiscal issues were not adequately addressed (Brazil, which did not forcefully address the pension system and intergovernmental relations, in contrast to the effort to address structural fiscal reform in Argentina and to a lesser extent in Greece), while in other countries non-fiscal issues were largely responsible for ongoing inflation levels (Mexico and initially Colombia). Countries that started with a large fiscal deficit and reduced it only slowly experienced a lengthy disinflation process (Hungary, Greece).

  • Efforts to reduce nominal rigidities in order to lower the costs of inflation inertia during stabilization programs can be helpful. Price and wage controls can prove useful, especially in helping reduce the initial output costs of disinflation, though they are at best temporary measures—designed to reduce the output costs of the disinflation—and hence the disinflation effort needs to be backed by sound macroeconomic fundamentals. Steps taken during the stabilization period to enhance labor market flexibility also assist in the stabilization effort, including the modification or abolition of wage indexation.

Efforts to break inflation inertia, if backed by a sustained adjustment in the fundamentals, reduced the time it took to disinflate. Official wage and price freezes or slowdowns—particularly in the public sector—were a feature in all the countries that reduced inflation without becoming stuck at moderate levels. Countries that banned wage indexation at the outset of the program disinflated quicker without becoming stuck at moderate levels (Argentina, Brazil, Croatia, and initially Mexico), although other rigidities in the labor market sometimes implied a heavy cost in terms of employment (Argentina). Two countries continued in practice with wage indexation: Chile where inflation fell only gradually (even against the background of weak labor market conditions), and Colombia which still has a rather high inflation level.

  • Exchange rate anchors lower inflation pressures rapidly but the real exchange rate appreciation that typically follows threatens medium term balance of payments stability.

Virtually every country that tried to disinflate initially relied on the exchange rate as the nominal anchor. Success in reducing inflation rapidly and at low output cost with an exchange rate peg depended on the accompanying fiscal and monetary measures. In particular, as the anchor became perceived as credible, wage and nontradable price inflation pressures moderated. However, residual rigidities and entrenched expectations typically led to a period of real appreciation of the exchange rate. Thus maintenance of the inflationary gains from the initial stabilization often required a subsequent fiscal or monetary tightening to bring inflation down further.

This pattern did not hold in a few countries: there was no real appreciation in Croatia which ended inflation almost overnight. This unusual achievement is probably due to the fact that at the outset of the program virtually all prices were linked to the deutsche mark, which was used as the peg. In Hungary, a narrow band backed by tight fiscal and monetary policies and strong output growth as a consequence of earlier structural reforms managed to contain the real appreciation.

In most other countries, however, the real exchange rate appreciated, typically by around 30–50 percent, which soon called into question the sustainability of the current account position.18 Subsequent movements away from pegs to crawling bands accommodated at least part of the ongoing domestic-foreign inflation differential (Greece). Countries that allowed their exchange rate to fully offset these differentials—moving to a backward-looking real exchange rate rule as in Chile or the recent floating exchange rate used in Mexico—weakened the nominal anchor, leading to more gradual disinflation. Real exchange rate rules also ran the risk of transforming one-time changes in the price level into permanent changes in the rate of inflation (Bufman and Leiderman, 1998). At the same time, such rules reduced the likelihood of subsequent balance of payments crises during the disinflation effort.

  • In countries where the capital account is open, policies need to adjust to capital inflows that threaten the maintenance of low inflation levels, and to capital outflows that threaten balance of payment sustainability. In economies that use an exchange rate peg as the nominal anchor and faced capital inflows, fiscal tightening is on balance a better choice than a relaxation of monetary policy, sterilization, and/or recourse to price or quantity based capital controls.

All the countries detailed here experienced capital inflows, and most also subsequent outflows, both of which complicated the disinflation process. These inflows result from the combination of relatively high domestic interest rates to fight inflation with the appreciation of the currency typical in an exchange-rate based stabilization. In some cases, the high interest rates were clearly the consequence of an excessively expansionary fiscal policy, in which case fiscal adjustment could be undertaken. In other cases, the inflows reflected remonetization of the economy or simply increased investment opportunities, including from privatization.

In managing such inflows, the exchange rate peg regimes that were useful in anchoring expectations in the initial stages of adjustment programs could later prove a liability. In the absence of exchange rate flexibility, fiscal policy had to be tightened, although this could prove politically difficult for some countries. The alternatives to fiscal tightening under an exchange rate peg were not especially effective. Monetary loosening was inconsistent with the goal of bringing inflation down further; sterilization was costly, ineffective over the medium term, and stored up future problems by causing an increase in the open foreign exchange position of the private sector which increased vulnerability; and imposing controls on short term flows typically lengthened maturities rather than reduced the magnitude of the total inflows. Similarly, the countries that were most successful in addressing outflows were those that aggressively increased and sustained the restrictiveness of monetary policy, although this implied a willingness to endure a potentially large shock to the real sector (Argentina) which was not always viewed as credible (Brazil, Mexico).

  • Structural reform is important to provide a base for strong and sustainable growth which also assists in the maintenance of low inflation, including by preventing noncompetitive pricing behavior by protected firms.

The countries that grew rapidly were often those that had the most far-reaching structural reform program (Argentina, Chile, Hungary), while those where growth has recently slowed were typically those with relatively weaker structural reforms, at least in some important areas (Brazil, Croatia, Colombia). Some structural reforms, such as a reduction in import tariffs, had the potential to lower price pressures, while a lack of reform could lead to price and wage inflexibilities. Typically these reforms were most likely to succeed if they were initiated at the outset of the program when political support was high.

  • Positive favorable shocks can be used to reduce inflation (opportunistic disinflation) and it is important to respond forcefully to adverse shocks.

All countries experienced external shocks during their disinflation efforts. Several were able to take advantage of positive shocks—such as improvements in the terms of trade—to make further inroads into inflation (Chile). It was important that external negative shocks—usually transmitted via capital flight—were dealt with forcibly if the disinflation effort was not to be lost (Argentina, Mexico, Brazil in 1994).

  • Signals of a government’s resolve to lower inflation via changes in institutional arrangements can have an important effect on underlying inflation pressures.

Several countries changed the institutional framework in ways that enhanced the authorities’ inflation-fighting credibility, such as the use by Argentina of a currency board arrangement, Chile’s move in 1991 to make the central bank more independent, and Greece’s commitment to join the ERM and euro area, all of which were effective in reducing inflationary pressures.

  • Finally, stabilization from high inflation levels supports economic growth, and there is little evident output cost of disinflating from moderate inflation levels either.

In the countries reviewed here, growth did not decline and usually accelerated following the initiation of the stabilization program, and then remained strong for several years thereafter.

V. Explaining Israel’s Disinflation Experience

We now return to the discussion of Israel, analyzing the disinflation period from the perspective of the lessons that emerge from the experiences in other countries. Clearly in Israel stabilization of inflation to low single digits has taken a long time. In large part this has simply reflected a lack of political consensus on the need to pursue single digit inflation. While the far ranging and bold initial stabilization program led to a sharp reduction in inflation from very high levels in 1985, the effort to continue the disinflation effort—meaning in practice persistence with tight fiscal and monetary policies—waned thereafter.

After the initial success in lowering inflation, the next sustainable decline in inflation had more to do with exogenous factors associated with immigration levels and world commodity prices than deliberate policy decisions to reduce inflation. The conclusion that there was little political support for further disinflation is supported by the official inflation targets for the period 1993–98, all of which lay between 7–10 percent, and both monetary and fiscal policies were relaxed prematurely during this time. It was only after both fiscal and monetary policies were tightened in 1997 and the government set a medium-term inflation target for 2001 (but not a target path) and low inflation targets for 1999–00 that were treated seriously by the BoI that further advances on reaching and sustaining low inflation levels were made.

Reflecting this lack of consensus to disinflate quickly or at all, the fiscal deficit has periodically been loosened which complicated the stabilization effort. Indeed the fiscal deficit was relaxed almost immediately after the 1985 stabilization program began. Some credibility may have been initially gained by the introduction of the 1991 Budget Deficit Reduction Law—with a target end point of budget balance—but this was not lived up to. The 1996 fiscal retrenchment law set a front-loaded medium-term profile, but with a less ambitious target point than under the previous program (an overall deficit of 1.5 percent of GDP by 200119).

Not only has periodic fiscal slippage had its impact on the credibility of the disinflation effort—it is hard to view the 16.5 percent public sector wage increase granted in 1994 as consistent with the official inflation target in that year of 8 percent—it has also implied that most of the disinflation effort has depended on restrictive monetary policy, a costly policy mix in terms of its impact on growth and complications from capital inflows. It is only recently that the fiscal sector has contributed more substantially to the disinflation effort, although there was some slippage in the domestic deficit due to the impact of the automatic stabilizers as growth has slowed. As for the composition of the fiscal accounts, expenditure has continually been curtailed on defense and subsidies, although there is room for further strengthening, including tax reform. Pressing areas to ensure a sustainable medium term fiscal position include further reform of the health sector and of the pension system.

Direct measures to reduce inflation were not a major part of the stabilization effort, except at the outset of the program, when they were politically important. Beyond the initial wage freeze, which was soon relaxed, and price controls for the first six months—which did play an important role in securing public support for the stabilization program and were effective in helping reduce inflation at a low initial cost in terms of unemployment—there was no strong effort to contain inflation inertia. Wage indexation was maintained, and real wages returned rapidly to their pre-stabilization levels. This rapid increase in real wages at the outset of the program was in essence blessed by the government-agreed wage agreements made within two months of the start of the program; Bruno and Piterman (1988) argue that the increases reflected a lack of faith by firms in the government’s initial resolve to deliver price stability and hence in the willingness to limit large nominal increases.20 In any event, the consequence was to undo much of the initial real adjustment achieved through the incomes policy aspects of the stabilization program, implying that an increased emphasis would have to be placed on the other (orthodox) components of the program if the disinflation effort was to be sustained. Thereafter, it was not until the exogenous increase in immigration levels that the wage setting process became more flexible. In recent periods, further labor market rigidities have been added, including the lowering of the backward-looking inflation threshold above which a COLA is paid, and the linking of, and then increase in, the ratio of the minimum wage to the average wage.

The exchange rate regime has in stages shifted toward greater flexibility during the disinflation process. Given the ongoing domestic-foreign inflation differential, the government’s resolve to protect the price anchor aspects of the stabilization policy was tested early in the period following the 1985 stabilization program. The initial devaluation in 1987, and the subsequent changes to the horizontal band between 1988-91, clearly signaled to the private sector that this nominal anchor had been weakened in order to keep the real exchange rate roughly constant and to thereby protect the balance of payments, at a time when there was no alternative and transparent anchor in place.21

This problem has gradually been resolved as a forward-looking inflation target has gained credibility and inflation has declined. The increased reliance on inflation targeting as a nominal anchor has been combined with a gradual exit from the exchange rate anchor, but the slow pace of the exit led to periodic conflicts as to whether the exchange rate or the inflation target was the dominant anchor. The credibility of the inflation target was enhanced by the firm monetary response to the initial price level effects of the depreciation at end 1998, and private sector inflation expectations fell back to levels close to the 1999–00 targets.

Large capital inflows from 1995–mid-1997 in response to the loose fiscal/tight monetary policy mix complicated the disinflation process and led to a sharp real appreciation of the exchange rate. The response of monetary policy—sterilized intervention—was not sustainable over the medium term, but managed for a period to contain inflationary pressures. The consequence, however, was a rapid build-up in the open foreign exchange position of the private sector—since the BoI was the counterpart for the inflows—which increased vulnerability, and which contributed to the sharp depreciation and inflation impulse when the risk of open foreign exchange positions was reassessed at end-1998.

Outside of extensive financial sector reform, which improved the effectiveness of monetary policy, far reaching structural reforms were not a major part of the initial stabilization effort, nor has there been a consistent emphasis on structural reform subsequently. The lack of widespread structural reform, which could have contained prices in noncompetitive sectors, precluded a potential downward pressure on the price level that could have aided disinflation (Ministry of Finance, 1998). The privatization program was begun late and has had a heavy focus on changing ownership of the government-owned banking sector without thus far corresponding efforts to increase competition in financial services. The most positive development has been the increasing competition in the telecommunications sector, where prices have declined sharply. Remaining areas for reform include, inter alia, the labor market, reform of the capital market including the pension system and taxation of financial income, increasing competition in goods markets, and reducing the size of the (large) government sector.

Turning to the other lessons that emerge from the international experience of disinflation, Israel was particularly successful in capitalizing on several positive external shocks. These included the decline in oil prices at the early stages of the stabilization program, the flexibility added to the labor market during the high immigrant inflows, and later declines in import prices. The government has frequently endeavored to build credibility by signaling its policy resolve such as by announcement of the two medium-term fiscal retrenchment paths, and the announcement of a medium-term inflation target, although the actual effect of these measures in lowering inflation is difficult to determine since in each case the resolve of the government was not fully believed. Finally, the link between disinflation and growth has been mixed. The initial disinflation effort was achieved at no immediate cost to growth, although this came later as the initial consumption boom faded. Recent disinflation efforts took place during a significant growth slowdown, in part a reflection of the previous poor policy mix, as well as the unwinding of extraneous factors.

VI. Strategy for the Future

By the end of 1999 and the start of 2000, the goal of moving Israeli inflation to the low levels of the better performing industrial countries was well in sight. Consolidating this achievement will require an appropriate policy environment, the elements of which should include: (i) fiscal policy restraint, with further consolidation of the underlying fiscal position; (ii) monetary policy aimed toward sustaining the recent low inflation levels; and (iii) bold structural reforms to move the economy to its potential level of growth as soon as possible.

To bolster these policies, the inflation experiences of Israel and the other countries studied here suggest the need for changes in institutional arrangements to provide the best chance of sustained low inflation levels and improved economic performance.

  • Central Bank operational independence and policy goals

International experience suggests that the achievement and maintenance of low inflation and sustained growth is more likely if monetary policy has the primary goal of maintaining low inflation, and if the central bank is given the operational independence to achieve its goals. The inflation target itself can be specified by the government. The inflation experience of Israel, especially that prior to the stabilization program, indicates the cost of not providing the BoI with the independence to use the instruments of monetary policy toward the inflation goal, and using monetary policy to support goals for which it is not well suited. The Levin Committee recommendations on the appropriate policy objectives and operational practices for the BoI offer a suitable approach.

  • Inflation targeting regimes

The worldwide experience with inflation targets is brief—mainly restricted to the 1990s—and hence the most effective mechanisms under such a regime are still being tested. Nonetheless, theory suggests that to be most effective at guiding monetary policy (which acts with a lag) and to enhance certainty for the private sector, the inflation targets should be set over the medium term (at least two-three years) rather than on a year-to-year basis as currently in Israel.22 The adoption of such a framework would increase the ability of the central bank to maintain low inflation on average, while taking account of whatever short-run tradeoffs might exist between inflation and economic activity. Further, most inflation-targeting countries (such as Australia, Canada, New Zealand, and the United Kingdom) have at least the operational (if not the actual) inflation target based on underlying rather than overall inflation, so that monetary policy is not hostage to fluctuations in volatile prices. Such a shift would contribute to the success of monetary policy in Israel, which has in the past tended to respond to short-term fluctuations in prices of fruits and vegetables and housing.23 Note too that the experience to date suggests that, while the monetary authorities need not have goal independence, they must have a reasonable degree of instrument (operational) independence to meet the inflation goal (Debelle and Fischer, 1994) which bears relevance for changes in the central bank law.

  • Consistency of inflation targeting regime with exchange rate and other policies

Although Israel for some time operated with inflation targets in a crawling peg exchange rate regime, it is clear that there may well be conflicts between these two approaches to monetary policy. The question then arises as to which should have primacy when a conflict arises. Typically the conflict occurs when inflation is low and the real exchange rate appreciated, with the current account deficit becoming uncomfortably large. At that point there may be a short-run tradeoff between the current account and inflation targets: an expansionary monetary policy (cut in interest rates) will temporarily produce a real depreciation. Given that such a tradeoff is typically very short-term—especially in Israel—the real answer to the dilemma lies in the area of fiscal policy. Hence in general, particularly in economies open to international capital flows, the inflation target should predominate, and the exchange rate should be allowed to become flexible.

  • Fiscal policy framework

Several countries such as Australia, New Zealand, and the United Kingdom have recently adopted formal fiscal policy frameworks, stressing the transparency of the fiscal accounts and the setting of medium-term policy goals; Argentina has also just completed a transparency report in line with the IMF’s Fiscal Transparency Code. Israel was among the first in this decade to adopt a medium-term fiscal policy framework, but the credibility of the initial framework was undermined by the failure to follow it. Such a framework nonetheless can reinforce inflation and other economic performance, both by constraining potential occasional fiscal policy excesses, and by informing private sector expectations of future economic policy.

Israeli Inflation From An International Perspective
Author: Mr. David William Harold Orsmond and Mr. Stanley Fischer