Inflation expectations as derived from the Israeli capital market continue to drop. According to the Bank of Israel, inflation expectations have reached 1.1%, compared with 1.8% at the beginning of the year. Inflation expectations deriving from the capital market are defined as the difference between yields on unlinked government bonds and yields on CPI-linked government bonds (break-even inflation).
Estimates of inflation by market analysts exhibit the same trend: a sharp fall from 1.7% (which is below the mid-point of the government's price stability target range) to 1% (which is the bottom of the range). This is in effect the first macro figure belonging to the period of the conflict in the Gaza Strip, for it relates to developments between July 16 and August 15. Next month, inflation expectations should fall further, since only yesterday were figures released showing a worsening of the economic slowdown in Israel and a further decline in demand.
These worrying figures come on top of the one published last weekend: the Consumer Price Index rose just 0.1% in July. Without the housing item and certain other items which rose because of seasonal factors, the CPI would have registered its third monthly drop this year.
The housing item, which rose by almost 1%, is what tipped the balance. The index excluding housing fell by 0.2% in July to 101.1 points. The rise in fuel prices (which depend on world prices) and the seasonal rise in hotel accommodation prices also helped the general CPI reach positive territory.
A broader perspective reveals a picture that is worrying indeed: the numbers indicate that there is currently no inflation in the Israeli economy, and that without the housing item, the economy would be deeply in deflation. The index excluding housing has fallen by 0.7% since the start of the year, and by 0.5% in the past twelve months (July 2014 compared with July 2013). According to the trend figures, the rate of decline of the price index excluding housing in the period March-July 2014 was 1.5%. These numbers speak for themselves.
The general public tends to interpret an absence of inflation as something positive, preserving its purchasing power. The worrying part, though, is that the reason for the absence of inflation is a sharp decline in demand both at home (falling private consumption, chiefly of consumer durables) and overseas. The decline in Israel's exports can be expected to continue because of the sharp fall in economic growth rates in the US and Europe, Israel's two main export destinations.
Deflation, like inflation, generates a spiral effect: if expectations are of a future fall in prices (or even no change), consumers will stop consuming, because they expect to be able to buy more cheaply later. They thereby reduce demand, which itself leads to an additional fall in prices, and the cycle goes on. This is also the situation in Europe, and it has become a nightmare for Mario Draghi, governor of the European Central Bank. Japan has been deeply mired in this process for a long time, and has not managed to free itself from this destructive vicious circle despite all the efforts of the central bank and the government.
Next month, the numbers will only get worse, because the consequences of Operation Protective Edge will have their full effect on the CPI. Simply put, zero inflation may be a good thing, but the reasons that explain how the economy got into this situation are very negative, and indicate very adverse developments.
In general, for some time there has been no inflation in goods but only in services. Every Israeli consumer feels this: product prices, as competition grows, are falling, but services such as rents, financial services, law and accountancy, hotels and restaurants, are rising. Because of the slowdown and Operation Protective Edge, this rise too is likely to be curbed.
The absence of inflation is not an exclusively Israeli problem. Deflation is raising its head in Europe too. The main problem is that in economies such as Israel and Europe, where interest rates are near zero, almost all the tools for combatting it have run out. Several economists therefore predict that the Bank of Israel will have no option but to cut its interest rate again, to an unprecedented low (just 0.25%), by the end of this year or in early 2015, bringing Israeli rates below US rates. Such a situation will generate pressures that will weaken the shekel against the US dollar, which will support exports and growth.
Published by Globes [online], Israel business news - www.globes-online.com - on August 18, 2014
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