Challenges faced by Advanced Inflation Targeters:

The Case of Israel

Karnit FlugBank of Israel

Prepared for a Conference at the Czech National Bank,April 8 2008

Economic Performance of the Israeli Economy

GDP and Business-Sector Product)*1995-2008 (

6.6

5.4

2.8

4.2

2.9

8.9

-0.4 -0.6

2.3

5.2 5.3 5.2 5.3

3.2

8.5

6.6

3.0

4.9

2.8

11.3

-1.7-2.5

3.2

7.26.5 6.5 6.1

3.6

-5

-3

-1

1

3

5

7

9

11

13

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008F

GDP Business-sector product

•SOURCE: Central Bureau of Statistics.* BOI Forecast.

%

1.6

2.93.0

3.83.2

2.9 2.83.1

3.6

1.8

3.9

3.0

4.0

3.4

0.0

0.9

4.24.0

3.2 3.1 3.2

0.7

4.4

3.8

5.4

3.6

1.9

0

1

2

3

4

5

6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005* 2006 2007 2008

Deficit Target Actual Deficit

Budget Deficit**(percentage of GDP, 1995-2007)

*Percent of GDP; excluding credit extended. Until 1996, domestic deficit; from 1997, total deficit.*The data from 2000 refer to the deficit excluding the Bank of Israel’s profits.

Public Sector Debt,Percentage of GDP, 1995-2007 (year-end)

104.5 102.6 101.8 103.397.5

87.191.9

99.8 101.7 99.995.7

86.680.6

0

20

40

60

80

100

120

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

%

Rate of Unemployment1995-2007 (Annual)

%

SOURCE: Based on Central Bureau of Statistics Labour Force Survey.

6.8 6.6

7.6

8.69.0 8.8

9.3

10.310.7 10.4

9.08.4

7.3

0

3

6

9

12

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

-5.1 -5.0

-3.1

-0.9-1.4

-0.8 -1.1 -0.8

1.2

2.43.3 3.1

6.0

-6

-4

-2

0

2

4

6

819

95

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Current Account of Balance of Paymentsas Percentage of GDP, 1995-2007 (Annual)

•SOURCE: Balance of Payments, Central Bureau of Statistics.

Investment in Israel by Nonresidents(as percentage of GDP, 2000-2007)

Investment of Israeli Residents Abroad(as percentage of GDP, 2000-2007)

02468

101214161820

2000 2001 2002 2003 2004 2005 2006 2007

Direct investment Portfolio investment

0235689

1112141517

2000 2001 2002 2003 2004 2005 2006 2007

Direct investment Portfolio investment

SOURCE: Central Bureau of Statistics, Balance of Payments.

%

%

8,798

14,694

4,868

4,2177,251

2,0123,822

1,812

1,767

7233,626

755,062

5,058

9,790

14,9928,244

2,9414,548

2,381

2,0653,1542,708

9821,623

688

2,1493,336

270

10,276

6,649

7,064

Monetary Policy Regime

NIS/Currency-Basket Exchange RateNIS

0

1

2

3

4

5

6

7

8

08/8

6

08/8

7

08/8

8

08/8

9

08/9

0

08/9

1

08/9

2

08/9

3

08/9

4

08/9

5

08/9

6

08/9

7

08/9

8

08/9

9

08/0

0

08/0

1

08/0

2

08/0

3

08/0

4

08/0

5

08/0

6

08/0

7

Declaration of IT

Full-fledge ITAdoption

of IT

Inflation and Inflation Targets

1-32006

1-320041-32005

1-32007

Inflation Targets

1-320032-32002

2.5 - 3.520013-4200041999

7-1019987-1019978-1019968-111995

81994101993

14-151992

0

1

2

3

4

5

6

7

Austra

liaIce

land

United

Kingdo

mIsr

ael

Norway

New Zea

land

Spain

Finland

Korea

Canad

aSwed

enTha

iland

Columbia

Czech

Rep

ublic

Chille

PeruPhil

ippines

Poland

Mexico

Hungary

South A

frica

Brazil

Target Center

Developing Countries Developed Countries

Inflation Targets in the WorldA

nnua

l Inf

latio

n Ta

rget

Monetary Policy

Rate of Inflation in Last 12 Months, Inflation Rate of Inflation in Last 12 Months, Inflation Expectations* and Inflation Targets, Expectations* and Inflation Targets, 19941994--20082008

-3

-1

1

3

5

7

9

11

13

15

17

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Inflation during previous 12 months

Inflation target

%

-3

-1

1

3

5

7

9

11

13

15

17

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

*For 12 months, as derived from the capital market.

Inflation Expectations

-5

0

5

10

15

20

01/9

406

/94

11/9

404

/95

09/9

502

/96

07/9

612

/96

05/9

710

/97

03/9

808

/98

01/9

906

/99

11/9

904

/00

09/0

002

/01

07/0

112

/01

05/0

210

/02

03/0

308

/03

01/0

406

/04

11/0

404

/05

09/0

502

/06

07/0

612

/06

05/0

710

/07

03/0

8

Bank of Israel interest rate

Actual Inflation

%

Bank of Israel Interest Rate, and Actual Bank of Israel Interest Rate, and Actual Inflation*, Inflation*, 19941994--20082008

*In last 12 months.

Bank of Israel Interest Rate, Inflation Bank of Israel Interest Rate, Inflation Expectations*, and the FedExpectations*, and the Fed’’s interest Rate, s interest Rate,

19941994--20082008

0

2

4

6

8

10

12

14

16

18

01/9

406

/94

11/9

404

/95

09/9

502

/96

07/9

612

/96

05/9

710

/97

03/9

808

/98

01/9

906

/99

11/9

904

/00

09/0

002

/01

07/0

112

/01

05/0

210

/02

03/0

308

/03

01/0

406

/04

11/0

404

/05

09/0

502

/06

07/0

612

/06

05/0

710

/07

03/0

8

Bank of Israel interest rate

Fed's interest rate

%

*For 12 months, as derived from the capital market.

Challenges

-5-4-3-2-101234567 Deviations from above Deviations from below

Rate of Inflation in Last 12 Months Inflation Targets

2003 2004 2005 2006

%

Rate of Inflation in Last 12 Months, Rate of Inflation in Last 12 Months, Inflation Targets and Deviations from Inflation Targets,Inflation Targets and Deviations from Inflation Targets,

20032003--20082008

2007

2008

Price Index and Shekel/Dollar Exchange Rate )Rate of change over 12 months, up to February 2008(

-4

-2

0

2

4

6

8

10

12

01/97

07/97

01/98

07/98

01/99

07/99

01/00

07/00

01/01

07/01

01/02

07/02

01/03

07/03

01/04

07/04

01/05

07/05

01/06

07/06

01/07

07/07

01/08

Percent

-16

-11

-6

-1

4

9

14

19Price index Exchange rate

Pass-Through from Exchange Rate to Prices:International Evidence and the Israeli Experience

Source: Choudhri and Hakura (2003) and bank of Israel estimetes

0.50.3Israel0.20.15Emerging Markets0.10.05Developed Economies

Over 1 YearOver 1 Quarter

In the second half of 2007 the Pass-Through has dropped sharply.

Volatility of the Exchange Rate in Israel and in Developed and Developing Countries

1997-2007

00.5

11.5

22.5

33.5

44.5

5

Singapore

Canada

Israe

lMex

icoUnite

d Kingdom

ChileUnite

d Stat

esNorw

aySwed

enPolandIce

land

Czech

Repub

licSouth A

frica

Korea

Developing CountriesDeveloped Countries

a SD of monthly depreciation against the US$. For US - US$ against synthetic €.

Volatility of Inflation in Israel and in Developed and Developing Countries

1997-2007

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

USACanad

a UK

ChilleSwed

enSingap

urNorw

aySouth A

frica

Korea

Mexico

Israe

lPolandIce

land

Czech

Repub

lic

Developing CountriesDeveloped Countries

Commodities and Oil Prices)06 /2001-03/2008 ,100=06/2001 (

0

50

100

150

200

250

300

350

400

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Dec-06

Jun-07

Dec-07

$

Oil PricesCommoditiesNon Energy Commodities

Index of Real Exchange Rate by Trading Partners )01 /1997-03/2007 (%

•A rise in the index indicates depreciation.

•The figure for March 2008 is calculated from spot exchange rates known for the half-month, our forecast CPI from the monthly model, and an extrapolation of inflation in the countries whose currencies are in the currency basket.

•SOURCE: IFS data. For November 2007 to March 2008, Bank of Israel calculations.

90

95

100

105

110

115

120

125

130

135

01/97

07/97

01/98

07/98

01/99

07/99

01/00

07/00

01/01

07/01

01/02

07/02

01/03

07/03

01/04

07/04

01/05

07/05

01/06

07/06

01/07

07/07

01/08

115.6

Most Recent Developments:• A two day intervention (during 13-14/03/08) in FX

market where the Bank of Israel purchased FX due to disorderly sharp appreciation of the NIS.

• An announcement of the intention to purchase FX at an amount of some 25 million US$ per day over the next 2 years aimed at raising FX reserves to a more adequate level of 35-40 billion US$.

• Two consequtive reductions of interest rates for March and April by 0.5% each

March 13-14, 2008

Shekel/Dollar

Shekel/Euro

-2.62%

-2.52%

The Change in Foreign Exchange Reserves($,1998 - 2007)

Source: IMF

-100%-50%

0%50%

100%150%200%250%300%350%400%450%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

World Reserves OECD Non OECD Israel Eurozone OECD ex Eurozone

Final Comment• During the Inflation Targeting Regime we

had high volatility of inflation and frequent episodes where inflation was outside the target range.

• However, expectations for inflation were always, in recent years, within the inflation target range.

• Thus, by anchoring expectations within the price stability range, inflation targeting has provided a stable environment to economic agents .

Thank You