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It has been a long time since we had negative inflation. The last one, in December 2001 (-0.1 percent), was followed by seven months of high inflation, which led analysts to project that in 2002 inflation would hit 8 percent.

But now that August's CPI was negative, the prevalent hypothesis is that inflation will be negative in the months to follow as well, so that 2002 will end with a more reasonable rate of 5 or 6 percent. This would still be more than the target rate set at the beginning of the year (2-3 percent), but considering that in the last three years (1999-2001) we were off in the other direction, not making the target this year is not the worst that could happen. It isn't the worst because the 12-month lookahead is for 2-2.5 percent, which is fully-fledged normalcy.

Two things caused inflation to soar in the first half of 2002: irresponsible budgetary policy and misguided interest policy. The Finance Ministry planned the budget for 2002 on a growth assumption of 4 percent, although even then this forecast was entirely baseless. This budget enabled the finance minister to carry on with excessive expenditure, and only when it became clear even to laymen that the deficit would reach 6 percent and the public started hoarding dollars did the minister get a grip on himself and declared a substantial budget cut.

At the same time, Finance Minister Silvan Shalom and his team were applying extensive pressure on the governor of the Bank of Israel to slash interest. Klein eventually caved in and in December 2001 cut the rate by 2 percent - big mistake. The result was an inflation-condusive environment: an unleashed budget and a too-low interest rate.

The public got the message immediately and shifted its investments to dollars. Consequently, the shekel devalued and real estate prices went up. Imported goods followed suit, as did everything else - until in mid-2002, inflation reached dangerous heights.

But things changed in June. Klein hiked interest to 9.1 percent and Shalom cut the deficit in the budget of 2003 to 3 percent and made a crucial announcement: no more talk of interest and growth; the only thing that counts now is stability.

That is why now when some treasury officials are once again calling for interest cuts, they should be reminded of the recent lesson we have learned. They should be reminded that prices are still dependent on the exchange rate; it was a currency devaluation that caused a price rise in the first half of the year, and a revaluation that led to August's negative inflation.

The governor has also learned his lesson from the December affair, and will be extra careful. He will probably not reduce the interest rate at all before October, and if he does it will be very moderately, as he did before December 2001. Obviously, it is the big difference between the Bank of Israel's interest and that of the Fed that keeps the exchange rate stable and thus also inflation.

The volatile geo-political situation also calls for Klein to be cautious. The intifada is still very much in force, and now there is also the threat of a war in Iraq, which might undermine what is left of growth and investment, cause an even bigger hole in the budget, chase away capital once again, lead to an inevitable devaluation - and to inflation.

Since interest cuts send people buying dollars and thus devalue the shekel, it will probably take a very long time before we see interest rates like those of December 2001 again.