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Israelis should not worry about deflation, Bank of Israel Governor David Klein said yesterday.

Despite the 0.5 percent drop in the consumer price index last month - which stunned forecasters, all of whom had predicted a slight rise - Klein said the central bank should stick to its monetary policy of gradual interest rate reductions rather than further shock the market with steep interest rate cuts.

"As long as we continue to experience low inflation within the multiannual target range, and as long as there are no irregularities in the currency and bond markets, we will continue lowering interest rates," Klein told those attending an Israeli Management Center conference in Tel Aviv. "There is no danger of deflation in Israel, neither from the perspective of dropping prices nor from the perspective of dropping productivity," adding that the economy is undergoing a slow process of exiting the recession.

Klein dismissed criticism that the Bank of Israel had failed to achieve stable prices in 2003, saying inflation cannot be predicted scientifically. Terror attacks or even military activities, such as Operation Defensive Shield, cannot be predicted, he said. "The development of exchange rates and their effect on the CPI are hard to predict too," he said.

Inevitably, there are uncertainties in the background when the central bank designs policies. The stability of prices should be judged over the long term, not in a certain calendar year, the governor said.

Well done, government

On an upbeat note, Klein said that more indicators demonstrate that slow growth is resuming this year following two years of economic contraction. "There is a not-so-small chance that the improvement will continue in 2004," he said. "Israel does not have to settle for contracting GDP. Even under the current security conditions, we can achieve positive GDP growth per capita, meaning more than 2.5 percent a year. When discussing growth, we at the Bank of Israel think first and foremost about infrastructure investment. The mission on the agenda - to invest some NIS 100 billion in infrastructures in order to narrow the gaps with other countries - should be spread over four-to-five years, with financing coming from non-banking capital market sources that still need to be developed," Klein said.

A major step in the right direction is the reform that unleashes the pension funds onto the capital market, the governor said. As for this and other reforms, Klein complimented the government on contributing toward reversing Israel's economic contraction. Contrary to past positions, Klein recognized that there is economic leadership today, praising certain government reforms.

"The social policies of the past decade are dead. It cannot carry on," he said, adding that this is what led to the necessity of sharp government cutbacks. "We must redefine our welfare policies, and create a new order of priorities." In particular, he pointed to wiping out poverty and encouraging a higher participation rate in the work force: Israel has one of the lowest in the Western world. He also suggested that as the government cuts back on its spending, it should ask whether or not the expenditures contribute to society.

Taking aim at a pet government priority, however, Klein suggested that while achieving economic growth via exports is viable, the government should not shoulder the burden of encouraging exports itself. "In my opinion, there is no place in the Israeli marketplace for a regime of directly encouraging exports. Exports should be made competitive in the world, which we can achieve through stable prices, a functioning foreign currency market, and public sector reductions," Klein said.

While exports are an important growth engine, they should not be nurtured through pinpoint capital injections, he said.