Israeli consumer prices fell 0.3% in the 12 months through September, a phenomenon economists call deflation. Many are predicting that in the coming months deflation will remain a feature of economic life. In other words, Israel has crossed the line from low inflation to low deflation.
There’s nothing to celebrate. Long-term deflation can wreak havoc on the economy. For that reason many economists expected the Bank of Israel to cut its base lending rate from its already record low 0.25% and perhaps even introduce so-called quantitative easing to push prices higher.
In the event, the bank’s monetary committee opted to do neither, at least for now, in the hope that another month or two’s wait would prove there’s no need. The committee indicated in its announcement that it hoped the dollar would keep strengthening against the shekel, spurring exports and lifting inflation back into the government’s target range of 1% to 3% annually.
Two factors are behind this deflation – one domestic and one imported.
In the last few months, perhaps even before that, there was a dramatic decline in consumer purchasing power due to the high cost of living. The average household spends 1,600 shekels ($425) each month over what it takes in. Just as importantly, many ordinary people are increasingly pessimistic about their economic prospects, as well as their country’s.
As a result, people are saving money rather than spending it. The second and third quarters saw a surprise drop in demand, and economists fear that this will extend into the fourth quarter. When consumers aren’t buying, prices decline, as the CPI has shown. The decline has been more for goods than for services.
In its statement Monday, the Bank of Israel made clear that it’s hoping the country’s deflation is a passing phenomenon and that inflation will return to its target levels without any special measures needed. But if it has to, would further rate cuts and quantitative easing do the trick?
Israel isn't the only country with deflation worries — it’s a global epidemic. Japan suffered deflation for many years and fears its return. In the European Union the red lights of price drops have already been switched on. Countries including Italy, Spain, Greece and Portugal are suffering from falling prices or getting close.
Like Israel, these countries are seeing lower prices not only due to local economic factors but also due to declining global commodities prices. The price of benchmark Brent crude oil fell to $85 a barrel Monday, a number Goldman Sachs forecast could drop to $80 next year due to a global supply glut.
Deflation is a dangerous process that eats away at the heart of economic life, especially if the decline is being caused by a chronic slowdown in economic activity, a decline in consumer purchasing power and the absence of demand.
People put off making purchases because they assume that prices will be lower if they wait. Businesses don’t invest in new plants and equipment on the assumption that it will cost them less in the future. As a result, demand for credit declines. There’s a risk of a downward spiral, with declining prices and declining demand chasing each other.
There are also some advantages, though mainly in the short term. As long as wages aren’t hurt by deflation, purchasing power grows, and goods and services become cheaper. Consumers can benefit.
But in Israel today there are strong anti-deflationary forces. Housing prices are still climbing and the depreciation of the shekel against the dollar is creating upward pressure on prices. The Bank of Israel may act to ensure that the shekel depreciation stays on course by buying foreign currency.
Perversely — from the point of view of its chief backer, Finance Minister Yair Lapid — the central bank hopes that the zero-VAT law will add upward pressure on housing prices by spurring demand.
Not all the deflationary forces are negative; the imported ones may have a positive effect. While consumer prices have dropped 0.3% in the last 12 months, they are down 1.4% after stripping out home prices. To a large extent, that difference reflects imported deflation due to dropping prices for gasoline, food and commodities.
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