Inflation may be the lowest in 28 years, but the Bank of Israel is not ready to abandon its tight monetary policy, even with the economy slowing sharply and unemployment rising. The central bank believes that Israel has the first chance in decades to bring inflation down to Western levels, and it knows rapid cuts in interest rates could hamper that goal.
The central bank did lower its key discount rate by 0.4 percentage point on Mar. 23 to 12.2%, the third cut in the past three months. However, since annual inflation is running at 5.6% in February, down from nearly 13% in mid-1996 (chart), real interest rates are still sky-high. In fact, because of several temporary factors, such as falling food prices, the consumer price index actually declined in four of the past six months. In addition to tight monetary policy, fiscal restraint, falling commodity prices, and the Asian crisis have also helped to restrain inflation.
Since inflation is widely expected to slip below 5% for the year, further rate cuts are likely, but they will come gradually. Bank of Israel Governor Jacob A. Frenkel believes that it's too early to declare victory in the battle against inflation. His stated objective is to achieve price stability gradually over time, and his policies have won the praise of the International Monetary Fund. The IMF also has called on the government to continue cutting its budget deficit, which at 2.4% of gross domestic product last year, was ahead of target.
However, many leading economists argue that the central bank's total focus on inflation is partially responsible for the deepening economic slowdown. After averaging 6% growth in the first half of the 1990s, Israel's GDP slowed to 4.5% in 1996 and to only 2.1% last year. For 1998, analysts project growth of no more than 2%. As a result, unemployment has risen from 6% in the second quarter of 1996 to 8% at the end of last year, and it is set to climb further. The fear is that Frenkel's likely victory over inflation will cost the economy dearly.