The Conquest of Israeli Inflation and Current Policy Dilemmas

During the five decades since the creation of the Bank of Israel in 1954 Israel experienced high and extremely variable inflation. Price stability (as defined by current international norms) was finally achieved at the beginning of the twenty first century. The paper divides the 1954-2015 sample into six sub-periods characterized by different inflation environments. The first part of the paper documents the impact of those different inflation environments on the average speed of individual price adjustments, the related pass-through from the exchange rate to domestic prices, inflation uncertainty, the extent of dollarization, relative price variability and the cost and time to maturity of the public debt. There are major quantitative differences in the above mentioned variables between the five inflationary sub-periods and the more recent price stability period. Among those are dramatic changes in the anchoring of inflation expectations, in the pass-through coefficient, inflation uncertainty, the speed of price adjustments, relative price variability, the (rather late) disappearance of dollarization in the real estate market and the benefits induced by price stability for the financing of the public debt. The paper provides an explanation for the fact that high inflation was stabilized in ?one shot? while the subsequent moderate inflation was stabilized gradually within an inflation targeting framework. It argues that the second stabilization fits into the mold of the opportunistic approach to disinflation. The second part of the paper focuses solely on the period of price stability. It documents major, non-inflation related, structural changes since the turn of the century and discusses current policy dilemmas. Among the major structural changes are a persistent switch from current account deficits to surpluses, increased flexibility in the labor market, a reduction in the size of government, separation of pension and provident funds from the banking system and the emergence of a corporate bond market. Particularly remarkable is the macroeconomic resilience of the Israeli economy to the world financial crisis. As in many developed economies both the inflation gap and the output gap are recently in the negative range implying that, on both counts, monetary policy should be expansionary. The current policy rate is indeed almost at the zero bound. On one hand this policy, along with occasional interventions in the forex market, partially offsets overvaluation pressures on the exchange rate. On the other it reinforces a nine year long cycle of price increases in the real estate market.