Abstract
This Selected Issues paper examines Israel’s monetary policy regime with an eye toward developing some understanding of why breaches have been occurring and how to address them. The paper provides a brief history of Israel’s experience with inflation and inflation targeting. It examines several institutional aspects of inflation targeting and compares Israel with other emerging market regimes. Various procedural issues associated with implementing an inflation-targeting regime in Israel are examined. The paper also analyzes active labor market policies in Israel.
I. Inflation-Targeting Practices in Israel1
A. Introduction
1. Inflation-targeting frameworks have been adopted by a number of countries in recent years. New Zealand was the first country to target inflation in 1990, followed by Canada (1991), the United Kingdom (1992), and Sweden, Finland, and Australia (1993). More recently, however, a number of emerging market countries—including Brazil, Chile, the Czech Republic, Israel, Poland, and South Africa—have also moved to inflation-targeting regimes. When industrial countries changed their monetary framework after disappointing experiences with monetary aggregate targeting or fixed exchange rate regimes, they did so with fairly well developed monetary and financial institutions in place and with a relatively long history of economic stability. In contrast, the emerging market countries have faced some additional hurdles in achieving price stability with inflation targeting, given their less well developed monetary and financial institutions.2
2. By most measures, Israel’s experience with inflation targeting has been quite positive, but some improvements can be made with respect to institutional and procedural characteristics. Inflation rates have fallen from triple-digit level in the 1980s to single-digit rates in recent years. Nevertheless, while inflation has become fairly benign, Israel has had difficulty in keeping inflation within the targeted range. For example, inflation was 4 percentage points above the upper target range in 2002 and well below the lower bound in 2003. Currently, both inflation and inflationary expectations have been on the rise, leading to some concern that the upper bound might be breached again and that the central bank might lose some credibility as a result.
3. The economic literature suggests several criteria for successfully achieving central bank credibility and, therefore, price stability:
First, the primary objective of monetary policy has to be price stability. In certain circumstances—namely, aggregate demand shocks—policy responses with inflation-targeting rules can achieve both economic stability and price stability; but, in all other cases, economic stability must be sacrificed to achieve price stability.
Second, the central bank must be independent and have sufficient resources to achieve its goals. The central bank must be free from political influences that would lead to price instability. As Frenkel (2001) has noted, many central bank laws have been rewritten in recent years, “and all in one direction, namely strengthening the independence of the Central Bank.” In addition, it must have the necessary infrastructure (staff, technology, and internal procedures) to be able to forecast future economic developments and provide decision makers with high–quality analysis.
Finally—and arguably the most important elements for achieving public credibility—the regime must be transparent and accountable.
4. This chapter examines Israel’s monetary policy regime with an eye toward developing some understanding of why breaches have been occurring and how to address them. Section B provides a brief history of Israel’s experience with inflation and inflation targeting. Section C examines several institutional aspects of inflation targeting and compares Israel with other emerging market regimes. Finally, Section D examines various procedural issues associated with implementing an inflation-targeting regime in Israel, and, in that context, section E illustrates how the appropriate stance of monetary policy can be gauged. Section F provides concluding remarks.
B. Israel’s Experience with Inflation and Inflation Targeting
Inflation in the 1980s and early 1990s
5. The Israeli economy became increasingly unstable in the late 1970s and early 1980s Bruno and Fischer (1986) attribute the instability to several factors—a major recession in the early 1960s with a very slow subsequent economic recovery and war and oil price shocks in the late 1970s. As a result of these shocks, the government gradually lost control of the inflationary process. As shown in Figure 1, by the mid–1980s, consumer prices were progressing at triple digit rates, the economy was failing, and financial markets were in turmoil.
Israel: Inflation, 1981–91
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Source: Central Bureau of Statistics.Israel: Inflation, 1981–91
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Source: Central Bureau of Statistics.Israel: Inflation, 1981–91
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Source: Central Bureau of Statistics.6. An economic stabilization program was implemented in 1985, anchored by a fixed exchange rate regime. Initially, the exchange rate was pegged against the U.S. dollar, and various capital controls were imposed to limit exchange rate volatility. In August 1986, the fixed exchange rate regime was modified, and the sheqel was pegged to a basket of five currencies—the U.S. dollar, the Deutsche mark, the U.K. pound sterling, the French franc, and the Japanese yen. The weights of each currency in the basket were determined according to the extent of Israeli trade with each country.
7. The stabilization program had moderate success in stabilizing inflation, but the fixed exchange rate regime was not sustainable. Inflation quickly fell to the 15-20 percent range once the program was implemented. However, with inflation in Israel far exceeding the level of inflation for those countries in the currency basket—likely owing to significant price rigidities—the exchange rate peg could not be held fixed for very long. This led to periodic surges in the demand for foreign currency and capital outflows and a gradual drawdown of foreign exchange reserves at the central bank. In 1989, Israel began to allow the exchange rate to fluctuate within a band in order to accommodate some of the exchange rate pressures. Initially, the exchange rate bands were fairly narrow, and market pressures often pushed the exchange rate to the upper range of the target. Over time, the Bank of Israel (BoI) was forced to both further widen the bands and raise the midpoint of the bands to accommodate market forces.
The move from an exchange rate peg to inflation targeting
8. In 1992, with inflation well below 20 percent, Israel shifted to a crawling pegwithin exchange rate bands and, eventually, to inflation targeting. 3 Initially, the BoI’s key interest rate was used almost exclusively to target the midpoint of the exchange rate bands, and the midpoint was allowed to increase gradually in response to changes in inflation differentials between Israel and the currency basket countries. In other words, the BoI was targeting both the exchange rate and inflation at this juncture, but less weight was being placed on the inflation target. Over time, the BoI put increasing weight on achieving lower inflation—i.e., on converging toward the inflation rates of other countries—by tightening the relationship between the midpoint of the bands and inflation targets and by widening the exchange rate bands. Although the exchange rate is still officially listed as an objective of the central bank, the exchange rate bands are sufficiently wide that this objective can essentially be ignored.
9. In retrospect, this policy was very successful in reducing inflation. Since 1992, both the inflation target and actual inflation have been lowered significantly (Figure 2). Inflation targets have been lowered from 14–15 percent in 1992 to 1–3 percent in 2003 and thereafter. Inflation has fallen as well, although there have been several breaches of the targets, on both the upside and downside of the target ranges.
Israel: Inflation, 1992–2004
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Sources: Central Bureau of Statistics; and Bank of IsraelIsrael: Inflation, 1992–2004
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Sources: Central Bureau of Statistics; and Bank of IsraelIsrael: Inflation, 1992–2004
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Sources: Central Bureau of Statistics; and Bank of Israel10. Nevertheless, this success could hardly have been predicted in 1992. There was considerable debate at the time about whether this was the right policy regime for Israel. At that time, the prevailing wisdom among most economists was that a monetary regime that focused on the exclusively on the exchange rate as a nominal anchor—rather than monetary aggregates or interest rates—was far more appropriate for a small, open economy such as Israel. Even among larger, more industrialized countries, the notion of using interest rates (rather than monetary aggregates) as operational instruments was somewhat controversial. Moreover, the concept of inflation targeting was relatively new. Just as importantly, however, there was also considerable debate as to whether Israel could achieve low and stable inflation rates similar to those in industrial countries. Monetary policy has had to compensate, to some degree, for the rapid pace of fiscal expansion over the past several decades, which has likely put upward pressure on both real interest rates and inflation. Finally, inflation targeting requires a well–developed framework for forecasting inflation. In contrast, Israel has had to confront a number of substantial structural shifts in the economy, involving legal, political, security, and cultural changes. Finally, the speed at which inflation has fallen is rather remarkable, given the rigidity of prices and the high initial inflation rate.
Recent experiences with inflation
11. Despite low inflation over the past few years, there have been several breaches of the inflation target in recent years (Figure 2). Indeed, it appears that inflation volatility has increased, rather than decreased, as inflation has fallen. 4 This suggests that Israel’s policy regime may be in need of further fine–tuning. There are several possible reasons for these breaches:
First, a number of institutional characteristics in Israel—which will be discussed in more detail in section C—could be contributing to undesirable inflation volatility. Israel lacks a monetary policy committee, for example, which could help shield the central bank governor from undue public and political pressures and would strengthen central bank independence. In addition, the Bank of Israel Law still mentions the exchange rate as an objective of monetary policy, which might create some confusion among the public as to the importance of price stability and, therefore, reduce the central bank’s credibility.
Second, a number of operational changes—to be discussed in Section D—could also be made in Israel that could improve the ability of the BoI to meet the inflation targets. In particular, the BoI appears to put a great deal of weight on outside forecasts of inflation in setting its policy rate—a practice that is viewed as potentially dangerous by many economists.
Third, a number of “high-inflation” mechanisms that remain after the double– and triple– digit inflation rates in the past, could confound the attempts of the BoI to meet inflation targets. For example, housing accounts for about 20 percent of the consumer price index (CPI) and is generally denominated in U.S. dollars. Thus, exchange rate movements are immediately translated into higher consumer prices. In addition to exchange rate links, there is still widespread indexation of wages and other prices to the CPI, which leads to rapid “second-round” effects in response to any change in the inflation rate.
Finally, fiscal policy still remains a challenge, as general government debt stands at just over 100 percent of GDP and deficits remain relatively high. Undoubtedly, this situation leads to higher real interest rates and tighter monetary policy than would otherwise exist.
C. Institutional Characteristics of Inflation-targeting Regimes
12. Central bank credibility is arguably the most important criterion for successful monetary policy. In recent years, there has been a strong movement toward using monetary rules (rather than discretion) to achieve and maintain central bank credibility. 5 Indeed, many countries—primarily industrial countries—have moved toward inflation-targeting regimes, which require fairly strict interest rate rules that focus exclusively on achieving price stability. The main appeal of rules (and inflation targeting in particular) is that they are easily communicated to the public, and, thus, the regime is fairly transparent. Nevertheless, while these regimes attempt to achieve credibility and price stability, they do so, perhaps, at the expense of some added volatility in economic activity.
13. Central banks must possess certain institutional characteristics in order to achieve and maintain credibility, regardless of whether price stability is the primary goal or one of several goals. 6 First, the goals and responsibilities of the central banks must be explicitly stated. In the case of inflation-targeting countries, price stability must be the only goal of monetary policy. It must be clear that, if shocks arise, for example, that raise the price level and lower economic activity (such as an oil shock), the central bank must act to stabilize the price level in lieu of supporting economic activity.
14. The central bank must have the ability to achieve its goals. This includes operational independence from direct, outside influences. 7 In addition, the central bank must possess the necessary funding to undertake its responsibilities. In the case of inflation-targeting countries, these resources could be quite extensive, since the central bank must be able to undertake in-depth analysis of current economic developments and develop models for forecasting future inflation. In the case of emerging market countries, having the necessary resources (staff and technology) may not be sufficient to make high-quality forecasts and analyses given their histories of economic and financial instability, underdeveloped financial markets, embedded institutions associated with high inflation, and lack of public credibility.
15. The central bank must be held accountable for its policy actions. In this context, inflation targets have advantages and disadvantages relative to other policy regimes. 8 On the one hand, inflation targets are a clear and easily measured yardstick for measuring central bank success. On the other hand, just as with other policy frameworks, there are long and variable lags between the policy instrument (the central bank’s key interest rate) and the final inflation objective. In addition, unexpected events may arise that may make it difficult to judge whether breaches in the target can be attributed to central bank policy errors or to unforecast economic shocks. Indeed, some countries have explicit “escape clauses” that relieve central banks of accountability in specific circumstances. New Zealand has the further requirement that the central bank governor’s job is subject to the achievement of the inflation target. But most countries opt for some form of “exceptional reporting”, which requires that the central bank explain the reasons for the breaches, the actions that it is taking, and an expected date for achieving the original target.
16. Finally, the central bank must operate as transparently as possible. The standard among industrial countries is to publish frequent inflation reports, which announce future inflation targets, the risks associated with reaching the target, and explicit reasons for why the current target may have been breached. Again, New Zealand has attempted to achieve a very high degree of transparency by providing the central bank’s inflation forecasts and by discussing possible policy responses in the event of unexpected economic shocks that would result in a breach of the inflation target.
17. Emerging market countries have also begun to adopt inflation targeting regimes. Despite their histories of price and financial market instability, their traditions of stricter controls and regulations, and their reluctance to communicate their economic outlook and policy intentions, these countries have taken important steps to gain the necessary credibility that industrial countries have achieved. In general, they have improved their governance structure by incorporating a broader range of perspectives into their decision-making process and by increasing the delegation of authority. They have enhanced transparency and accountability through regular press releases, inflation outlook reports, an ongoing dialogue with the private sector and media, and, in some cases, the publication of inflation-forecasting models.
18. Table 1 presents a snapshot of the institutional framework adopted by six of the emerging market economies that have adopted inflation-targeting regimes. 9 While there are a number of commonalities, there are also some important differences:
First, most countries have established price stability as the primary objective of monetary policy. In Israel’s case, exchange rate stability is still officially listed as an objective, but the exchange rate bands are so wide that, effectively, the exchange rate is not a direct concern of the central bank in setting interest rates. In 1998, the Levin Commission proposed that exchange rate stability not be listed as an objective of the central bank. As yet, this change in legislation has not been made.
Second, all of these countries—with the exception of Israel—have set up monetary policy committees, and most of these committees include non-central bank members. The primary advantage of a policy committee is that it brings several perspectives and experiences to the decision-making process. 10 In addition, since decisions are made by committee rather than by an individual, the committee is likely to be far less influenced by outside (public or private) pressures. This is particularly important for many emerging market economies, where the government has enjoyed a great deal of influence in setting interest rates or influencing bank behavior. In Israel’s case, again, the Levin Commission in 1998 recommended establishing a policy committee, but the necessary legislation has yet to be adopted
Third, there is no general pattern as to who sets the inflation target (the government, the central bank, or a joint decision). However, in all cases, the central banks appear to have the authority and responsibility for achieving the inflation target. In two cases, there are established “escape clauses”, which allow the target to be breached in specific extenuating circumstances. In the event of such a breach, regulations require either the central bank to indicate when inflation is expected to return to within the target range or for a new inflation target to be established.
Finally, most central banks issue quarterly inflation reports—again, Israel is an exception, publishing a semiannual report. The inflation reports differ in their content, although the trend is toward issuing model-based inflation forecasts with highly analytical discussions of the inflation outlook. Brazil has made the most progress in this area and is now fairly comparable to industrial country inflation targeters.
Selected Countries: Characteristics of Inflation-Targeting Regimes in Emerging Market Economies
Selected Countries: Characteristics of Inflation-Targeting Regimes in Emerging Market Economies
| Characteristic | Brazil | Chile | Czech Republic |
Israel | Poland | South Africa |
||||
|---|---|---|---|---|---|---|---|---|---|---|
| 1. | Primary objective | Price stability | Price stability plus others | Price stability | Price stability plus others | Price stability | Price stability | |||
| 2. | Decision-making body | |||||||||
| a) | Policy committee | Yes | Yes | Yes | No | Yes | Yes | |||
| b) | Non-central bank members | No | Yes | No | -- | Yes | No | |||
| c) | Executive responsibilities | -- | Yes | Yes | -- | Yes | Yes | |||
| 3. | Inflation target design | |||||||||
| a) | Target set by: | Government | Central Bank | Joint | Government | Central Bank | Government | |||
| b) | Escape clauses | No | No | Yes | No | No | Yes | |||
| 4. | Inflation report | |||||||||
| a) | Frequency of report | Quarterly | Quarterly | Quarterly | Semiannual | Quarterly | Quarterly | |||
| b) | Format of inflation outlook | |||||||||
| i) Forecast? | Fan chart | Fan chart | 2-year forecast | Fan chart | Point estimate | Fan chart | ||||
| ii) Discussion? | Analytical | Analytical | Analytical | Qualitative | Qualitative | Qualitative | ||||
| c) | Publishes | |||||||||
| forecasting models | No | No | No | Some | No | No | ||||
Selected Countries: Characteristics of Inflation-Targeting Regimes in Emerging Market Economies
| Characteristic | Brazil | Chile | Czech Republic |
Israel | Poland | South Africa |
||||
|---|---|---|---|---|---|---|---|---|---|---|
| 1. | Primary objective | Price stability | Price stability plus others | Price stability | Price stability plus others | Price stability | Price stability | |||
| 2. | Decision-making body | |||||||||
| a) | Policy committee | Yes | Yes | Yes | No | Yes | Yes | |||
| b) | Non-central bank members | No | Yes | No | -- | Yes | No | |||
| c) | Executive responsibilities | -- | Yes | Yes | -- | Yes | Yes | |||
| 3. | Inflation target design | |||||||||
| a) | Target set by: | Government | Central Bank | Joint | Government | Central Bank | Government | |||
| b) | Escape clauses | No | No | Yes | No | No | Yes | |||
| 4. | Inflation report | |||||||||
| a) | Frequency of report | Quarterly | Quarterly | Quarterly | Semiannual | Quarterly | Quarterly | |||
| b) | Format of inflation outlook | |||||||||
| i) Forecast? | Fan chart | Fan chart | 2-year forecast | Fan chart | Point estimate | Fan chart | ||||
| ii) Discussion? | Analytical | Analytical | Analytical | Qualitative | Qualitative | Qualitative | ||||
| c) | Publishes | |||||||||
| forecasting models | No | No | No | Some | No | No | ||||
D. Operational Issues and Potential Pitfalls
19. As discussed above, operational procedures are also important issues for the successful implementation of monetary policy. This section discusses some of the pitfalls of inflation-targeting regimes that should be avoided—with a particular emphasis on Israel. In order to focus the discussion, consider a central bank that has a pure inflation target objective. In this case, the policy interest rate is set according to the following rule:
where iT is the desired policy rate setting,
20.The interest rate rule in equation (1) suggests three important operational difficulties that must be addressed in order to successfully implement such a rule. First, the central bank must have a measure of the long-run real interest rate that is consistent with underlying long-run macroeconomic conditions. If the central bank’s perceived real interest rate is too high, for example, monetary policy will be too tight, and will result in prolonged breaches of the inflation target (from below) and slower economic activity. There are several ways to gauge the level of the long-run real interest rate using standard macroeconomic theory. For example, standard growth models predict that this rate must equal the rate of potential GDP growth. Measuring potential GDP growth is a difficult exercise even for stable, well–developed countries; obtaining measures for countries with recent, substantial structural changes poses an even greater challenge.
21. Israel relies on a CPI-indexed ten-year government bond for this reading. This approach could over- or understate the actual real rate to the extent that the price of the underlying security reflects risks that are not related to macroeconomic conditions (such as default or exchange rate risk). Indeed, the real ten-year interest rate has fluctuated between 2 and 6 percent over the past ten years. As discussed above, using a biased measure of the real rate means that the target may be breached over long periods of time. For example, the current reading on the real rate is about 4½ percent. With expected inflation over the next year within the target range, a reasonable range of policy settings would be 5½ to 7½ percent, in line with the current setting. However, if the real rate is actually 3 percent, this would suggest monetary policy is too tight and that there may be room for further easing.
22. The second potential obstacle for implementing an interest rate rule involves the response to deviations of inflation from the targeted rate. λ must be greater than 1 to ensure that inflation and inflation expectations return to the targeted level. For example, if expected inflation exceeds the target level, then the nominal policy rate must rise by more than the deviation, so that real rates rise, thereby squelching inflationary pressures. Clarida, Gali, and Gertler (1998) have shown that λ approaches a value of 2 for low–inflation countries. One recent study—Elkayam (2001)—suggests that Israel’s reaction to deviations is sufficiently strong to ensure long–run convergence. Still, that paper has some possible econometric problems, and staff estimates indicate that λ is close to 1 in Israel. 11 Therefore, a sluggish response to inflationary deviations could account for the periodic breaches of the target shown in Figure 2.
23. Finally, the central bank must have a reliable measure of inflation expectations. The central bank should use as much information as feasible to make its inflation forecast, including information that can be gleaned from private forecasters or from capital market instruments. Israel appears to place more weight on measures derived from capital markets than on its own, internal forecasting models. Unfortunately, this approach has two important drawbacks. First, market measures are biased and inefficient predictors of future inflation (Figure 3.). Over the past decade, market participants have (implicitly) overpredicted inflation by 1 percentage point, on average, and their forecast errors are highly correlated with information that was available at the time of the forecast. 12 If capital market predictions are still biased upward, this would be further evidence that monetary policy is still somewhat tight. 13
Israel: Inflation Expectations and Ex Post Inflation, 1992–2004
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Sources: Central Bureau of Statistics; and Bank of Israel.Israel: Inflation Expectations and Ex Post Inflation, 1992–2004
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Sources: Central Bureau of Statistics; and Bank of Israel.Israel: Inflation Expectations and Ex Post Inflation, 1992–2004
(Monthly, year-over-year percentage change)
Citation: IMF Staff Country Reports 2005, 134; 10.5089/9781451819571.002.A001
Sources: Central Bureau of Statistics; and Bank of Israel.24. More important, using market expectations induces price instability. As discussed extensively in Bernanke and Woodford (1997), “strict targeting of inflation forecasts is typically inconsistent with the existence of a rational expectations equilibrium.” The intuition for this argument is simple. Suppose that a shock occurs that will lead to higher (or lower) inflation in the future. If the central bank has 100 percent credibility, then the market’s best forecast of future inflation will be the targeted inflation rate. In other words, with a credible policy regime, the market forecast contains no inherent information about future deviations from the inflation target. Moreover, if the central bank is basing its interest rate rule on market expectations—which will not change in the event of inflationary shocks—then the central bank will not react to the shock. That is, if the central bank uses market-based measures of expectations exclusively to make interest rate decisions, any set of economic conditions would be consistent with “doing nothing”, and, hence, there will be no unique equilibrium.
25. In order to provide a solid anchor for market expectations and for the inflation-targeting regime, the BoI should rely more on its own forecasts of inflation. A number of models—ranging from reduced–form vector autoregressions to larger, structural models—have been developed in the Bank of Israel that could be given more weight in the decision process. In addition, the structural models could be used to explain inflationary developments and provide more credibility about future expected developments. 14
E. Gauging the Stance of Monetary Policy
26. Given the complexities of implementing an inflation-targeting regime—especially for countries with a recent history of high inflation—it is difficult for observers to gauge the appropriate stance of monetary policy. As a starting point, recall equation (1):
One could use econometric procedures to estimate the coefficients of the rule, although such an approach is fraught with pitfalls (short time series, endogeneity, etc.) and is beyond the objectives of this section.
27. Instead, once can use a rough rule of thumb to compare the actual, current policy rate with the “desired” policy rate, with a couple of assumptions. First, it seems reasonable to assume that the real long-term interest for most emerging market countries is around 4 percent. In addition, as previously discussed, econometric studies show that the most successful inflation targeters have a λ of about 2. Given the possible pitfalls discussed above, alternative comparisons could and should be made by changing either of these assumptions. For example, the real interest rate is probably much higher than 4 percent in rapidly growing countries, such as Brazil. In addition, there is a great deal of uncertainty associated with inflation expectations measures in all of the emerging market countries discussed in this chapter.
28. Table 2. presents stylized facts for six emerging market countries with inflation targeting regimes. These countries have also recently experienced various financial and economic crises. The “rule-of-thumb” policy rate—based on the assumptions in the previous paragraph—is shown in column 4. The last column shows the deviation between the current policy setting (column 1) and the “rule-of-thumb” policy rate. A positive deviation indicates relatively tight monetary policy, while a negative deviation indicates a relatively loose stance. According to these rough calculations, most countries appear to be accommodative, in light of relatively low inflationary expectations and signs of a faltering world economy. Israel’s stance appears slightly loose following a number of policy easings in early 2004. The Czech Republic, Chile, and Poland appear to be the most accommodative, which could present some risk of future inflationary pressures emerging. Brazil, however, is quite restrictive, which likely reflects its desire to further lower inflation in the longer term.
Selected Countries: Comparison of Current and Rule-of-Thumb Policy Rate Settings
(in percent)
Selected Countries: Comparison of Current and Rule-of-Thumb Policy Rate Settings
(in percent)
| Current Policy Rate | Expected Inflation | Current Inflation Target | Rule of Thumb Policy Rate | Deviation | |
|---|---|---|---|---|---|
| Country | (1) | (2) | (3) | (4) | (5) = (1)-(4) |
| Brazil | 17.25 | 5.8 | 5.1 | 10.5 | 6.8 |
| Chile | 2.25 | 3.0 | 2 to 4 | 7.0 | -4.8 |
| Czech Republic | 2.50 | 3.0 | 2¼ to 4¼ | 6.8 | -4.3 |
| Israel | 3.90 | 2.1 | 1 to 3 | 6.2 | -2.3 |
| Poland | 6.50 | 4.5 | 1½ to 3½ | 10.5 | -4.0 |
| South Africa | 7.50 | 5.5 | 3 to 6 | 10.4 | -2.9 |
Selected Countries: Comparison of Current and Rule-of-Thumb Policy Rate Settings
(in percent)
| Current Policy Rate | Expected Inflation | Current Inflation Target | Rule of Thumb Policy Rate | Deviation | |
|---|---|---|---|---|---|
| Country | (1) | (2) | (3) | (4) | (5) = (1)-(4) |
| Brazil | 17.25 | 5.8 | 5.1 | 10.5 | 6.8 |
| Chile | 2.25 | 3.0 | 2 to 4 | 7.0 | -4.8 |
| Czech Republic | 2.50 | 3.0 | 2¼ to 4¼ | 6.8 | -4.3 |
| Israel | 3.90 | 2.1 | 1 to 3 | 6.2 | -2.3 |
| Poland | 6.50 | 4.5 | 1½ to 3½ | 10.5 | -4.0 |
| South Africa | 7.50 | 5.5 | 3 to 6 | 10.4 | -2.9 |
F. Conclusions
29. Israel’s experience with inflation targeting has been quite positive, but some improvements can be made to institutional and procedural characteristics. While inflation has fallen to levels comparable to industrial countries, there have been several breaches in the target in recent years. This chapter suggests several reasons for these breaches and recommends measures to address them:
Israel lacks a monetary policy committee, which could shield the central bank from public and political pressures and would strengthen central bank independence. In addition, the exchange rate is still listed as an objective of monetary policy, a practice that might create some confusion among the public as to the importance of price stability and, therefore, reduce the central bank’s credibility. Both changes have been recommended by an independent commission and would require amending the Bank of Israel Law.
In addition, there are several ways in which Israel could make its regime more transparent, which would also improve credibility: publishing the inflation report on a quarterly basis (rather than semiannually) and providing more analytical content in the report regarding recent deviations and the BoI’s inflation forecast.
Also, a number of operational changes could be made to improve the ability of the BoI to meet the inflation targets. Market measures of the real interest rate are likely to be biased, and there is some evidence that Israel is slow to respond to expected target deviations. But, more important, the BoI appears to put a great deal of weight on outside forecasts of inflation in setting its policy rate, which is potentially dangerous. Putting more weight on internal forecasts would anchor inflationary expectations and improve central bank credibility.
A number of “high-inflation” mechanisms—dollarization and indexation—remain that also add to inflationary volatility and inertia. This creates extensive and very rapid pass-through. The government could take measures to reduce or eliminate these mechanisms, which would reduce inflation volatility.
Finally, general government debt and deficits remain relatively high and rely heavily on U.S. debt guarantees. Undoubtedly, these conditions put upward pressure on real interest rates and, due to the uncertainty of obtaining a guarantee, also likely add volatility to interest rates.
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Schaechter, Andrea, Mark R. Stone, and Mark Zelmer, 2000, “A Practical Guide to Inflation Targeting for Emerging Market Countries,” IMF Working Paper 00/202 (Washington: International Monetary Fund).
Sigal, Ribon, 2004, “A New Phillips Curve for Israel: Theory and Some Evidence,” Discussion Paper No. 2004.11 (Jerusalem, Israel: Bank of Israel).
Taylor, John B., e.d., 1999, Monetary Rules (Chicago: University of Chicago Press).
Allan D. Brunner.
Technically, “price stability” means an inflation rate of zero. However, it is well known that most measures of inflation are biased upward, and there are some compelling reasons for having a small, positive inflation rate. Therefore, this paper will assume that “price stability” actually means “low and predictable” inflation.
See Elkayam (2001) and Leiderman and Or (2000) for a more complete history of monetary policy in Israel. Also, see Leiderman (1999) for a set of research papers analyzing the disinflation process.
Roger and Stone (2004) report that disinflating countries miss their inflation target nearly 60 percent of the time, but stable inflation regimes breach their targets only 30 percent of the time.
For a comprehensive debate on the use of monetary rules, see Taylor (1999).
See Debelle (1997) and Schaechter et al. (2000) for a survey of institutional characteristics of industrial and emerging market inflation-targeting countries.
As pointed out by Debelle (1997, p.7), “independence of the central bank need not be associated with the freedom for it to choose its own goals, [but rather it must be unconstrained] in pursuing the assigned goal.”
See Debelle (1997) for a more extensive analysis of this issue.
Several additional emerging market economies have recently adopted inflation-targeting regimes, including Colombia, Hungary, Korea, Mexico, Peru, Philippines, and Thailand. See Roger and Stone (2004) for a review of their initial experiences.
This is particularly important if the central bank also sets the inflation objective.
For example, if equation (1) is estimated using actual future inflation as a measure of expected inflation, using instrumental variables, and including a lagged dependent variable, λ is estimated to be about 1.
For example, if one regresses the forecast errors on lagged CPI, GDP, and interest rates, the null hypothesis of zero coefficients is easily rejected at conventional significance levels.
The BoI related to the Article IV mission that, in a recent paper by David Elkayam and Alex Ilek (BoI), it was shown that one cannot reject the hypothesis that these inflation expectations are unbiased and efficient.
Elements of these models have been discussed in Sigal (2004) and Djivre and Sigal (2000a and 2000b).
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DATA APPENDIX
We used the following data sources for the regression analysis.
| Variable | Definition | Source |
|---|---|---|
| Unemployment rate | Unemployment in percent of labor force. | OECD Labor Market Statistics Database. |
| Labor force participation rate | Labor force in percent of population (aged 15–64 years). | OECD Labor Market Statistics Database. |
| Long-term unemployment rate | Unemployed for 12 months or more in percent of labor force. | OECD Labor Market Statistics Database. |
| Minimum Wages and Median Wages | OECD Labor Market Statistics Database. | |
| ALMP Expenditures and PLMP Expenditures | In percent of GDP. | Expenditures from OECD Labor Market Statistics Dabase; GDP from World Economic Outlook database (IMF). |
| Unionization | Trade union members in percent of employees | OECD Labor Market Statistics Database. |
| Gross replacement rate | Average of the gross unemployment benefit replacement rates for two earnings levels, three family situations and three durations of unemployment. | Benefits and Wages, OECD (2004). |
| Per capital real GDP growth | Real GDP (in national currency units) divided by population, annual percent change. | World Economic Outlook database (IMF). |
| Employment Protection Index | Range 0–2. | Nickell, Nunziata, Ochel, and Quintini (2001) show estimates in 5-year intervals up to 1995. Data within the intervals are intrapolated. Data from 1996 onward is assumed to be constant. |
| Collective Bargaining Coverage | In percent. | Nickell, Nunziata, Ochel, and Quintini (2001) show estimates in 5-year intervals up to 1994. Data within the intervals are intrapolated. Data from 1996 onward is assumed to be constant. |
| Variable | Definition | Source |
|---|---|---|
| Unemployment rate | Unemployment in percent of labor force. | OECD Labor Market Statistics Database. |
| Labor force participation rate | Labor force in percent of population (aged 15–64 years). | OECD Labor Market Statistics Database. |
| Long-term unemployment rate | Unemployed for 12 months or more in percent of labor force. | OECD Labor Market Statistics Database. |
| Minimum Wages and Median Wages | OECD Labor Market Statistics Database. | |
| ALMP Expenditures and PLMP Expenditures | In percent of GDP. | Expenditures from OECD Labor Market Statistics Dabase; GDP from World Economic Outlook database (IMF). |
| Unionization | Trade union members in percent of employees | OECD Labor Market Statistics Database. |
| Gross replacement rate | Average of the gross unemployment benefit replacement rates for two earnings levels, three family situations and three durations of unemployment. | Benefits and Wages, OECD (2004). |
| Per capital real GDP growth | Real GDP (in national currency units) divided by population, annual percent change. | World Economic Outlook database (IMF). |
| Employment Protection Index | Range 0–2. | Nickell, Nunziata, Ochel, and Quintini (2001) show estimates in 5-year intervals up to 1995. Data within the intervals are intrapolated. Data from 1996 onward is assumed to be constant. |
| Collective Bargaining Coverage | In percent. | Nickell, Nunziata, Ochel, and Quintini (2001) show estimates in 5-year intervals up to 1994. Data within the intervals are intrapolated. Data from 1996 onward is assumed to be constant. |
The OECD Labor Market Statistics Database is available at (http://www1.oecd.org/scripts/cde/members/lfsdataauthenticate.asp). The OECD benefit and wages database is available at http://www.oecd.org/document/0/0,2340,en_2825_497118_34053248_1_1_1_1,00.html#statistics.
We included 20 OECD countries for the years 1985-2002. The countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the UK, and the US.
Gil Mehrez and Franziska Ohnsorge.
The unemployment rate for those without work for at least 12 months overestimates long–term unemployment because it includes some new entries into the labor market. In comparison, the long–term unemployment rate for those seeking work for at least 27 weeks increased to 4.2 percent (40.8 percent of unemployed) in 2004 from 3.9 percent (36.3 percent of unemployed) in 2003.
In 2002, prior work requirements were increased from 180 out of 360 days or 270 out of 540 days to 360 out of 540 days. The benefit duration for those below the age of 25 years levels were reduced for recipients of income maintenance assistance, eligibility requirements for benefit recipients (including employment tests) were tightened, and other social benefits, such as child allowances, were cut. Nevertheless, the replacement rate remains higher than in some European countries, albeit lower than in the northern European countries. Additionally, for some population groups, including single parents, incentives to work part–time or not at all while receiving income maintenance assistance remain strong.
A reduction in unemployment benefits to participants in vocational courses in 2002 led to a decline in demand for such courses from unemployment benefit claimants. Most participants in these courses are now longer–term unemployed on income maintenance assistance.
Akerlof and Yellen (1990) show that workers’ efforts are affected by their feelings of loyalty toward the firm, partly determined by wage comparisons with other firms.
Likewise, in the presence of hiring and firing costs, lack of information could result in higher unemployment rate as the uncertainty would cause firms to delay hiring.
Lise, Seitz and Smith (2003), however, find that in one province a substantial number of program participants would have found employment regardless of the program.
This contrasts with Estevao (2003), who estimates results for employment in the business sector alone, arguing that the effect of ALMPs on unemployment is distorted by its effect on labor force participation. Instead, we explicitly test the relationship between ALMPs and participation rates to account for this effect and find no significant relationship. Estevao (2003) also argues that the fact that participants in ALMPs are not included in unemployment data distorts any regression results based on unemployment. He therefore chooses employment as the dependent variable. The argument does not apply to participants of job search programs (the majority of ALMP participants), however, who remain classified as unemployed. Additionally, employment data are also distorted by the artificial employment increase generated by participants in wage subsidy or public employment programs. Until cross–country data on ALMP participants become available, the issue cannot be resolved satisfactorily.
A simple regression of unemployment on ALMP and PLMP, including country dummies and trend, shows strongly significant positive coefficients for both kinds of labor market policies, indicating the possible existence of simultaneity.
We do not include interaction terms between institutions and macroeconomic shocks. Nickell et al. (2005) find that such interaction terms do not explain unemployment.
Much of the data have already been presented in comparison with Israel and are further described in detail in the appendix. We do not include data on mobility or on tax wedges because complete and consistent data on these two variables are not available for the whole period.
We conducted several robustness tests, which generally did not affect the qualitative results. A time trend was insignificant and did not affect the other parameter estimates significantly. The same applied to the exclusion of the variables assumed to have the largest measurement error, the employment protection index and the collective bargaining rate, as well as to the exclusion of the replacement rate which may be correlated with PLMP. Likewise, the use of three–year averages to reduce the possibility of bias due to serial correlation in the error term yielded larger coefficient estimates for ALMP, as expected, but reduced their significance for long–term unemployment somewhat to 12 percent.
Nevertheless, because of the large standard error of the coefficient estimate for ALMP in the equation for unemployment, the coefficients on ALMP are not significantly different in the equations for unemployment and long–term unemployment.
The paucity of instruments makes the country dummies key to identifying the equations. Fixed–effects regressions therefore yield very weak results.
We conducted several robustness tests, which yielded qualitatively similar results. Inclusion of a trend or an autoregressive AR(2) process in the second–stage regression does not affect the coefficient estimates. The inclusion of initial unemployment has no significant effects. Using three–year averages reduces the significance of ALMP to the 16 percent level. It also strengthens the correction for endogeneity in PLMP.
