The Israeli Consumer Price Index has fallen 0.3% for the month of September. This drop follows a 0.1% reduction in August.
From September 2013 to September 2014, the Index has fallen 0.3% overall. If housing is not included in the index, it has fallen 1.2% over that period. Based on these numbers and trends, economists and investors are questioning if the Israeli economy is entering into a period of deflation.
The definition of deflation is when prices in an economy fall. The effect of prices falling quickly in an economy, if left unchecked, can be catastrophic – unmanaged deflation creates a spiral where prices fall, which causes people and companies to hold off on purchases assuming prices will fall further. The lack of sales/demand causes companies to downsize, which further brings down people’s spending, again causing lower sales, which lowers prices….until factories and businesses close, and the economy is in tatters.
Central banks generally combat deflation by cutting interest rates, which allows money to borrowed cheaply. This encourages spending, which picks up demand, and therefore prices.
However, the Bank of Israel interest rate is already at 0.25%, having been cut twelve times since 2011.
This low interest rate has led to a general rise in asset prices, such as real estate and stocks. When money is “cheap” to borrow, people will borrow it to invest elsewhere, hoping to make more than the interest they will have to pay.
While the numbers suggest that Israel is entering a deflationary period, deputy governor of the Bank of Israel Nadine Baudot-Trajtenberg disagrees. “We are not seeing deflation this year,” she argues. In Trajtenberg’s opinion, falling prices in the consumer prices index are due to the falling price of imports – oil, commodities, and food, in particular. (Oil prices have fallen by over 20% since June.) She sees this as a positive, as it will help Israelis with their cost of living without harming the economy.
“This is something welcome and positive for the Israeli economy,” Baudot-Trajtenberg explained. “It’s not just the low inflation. Part of the reduction of prices is a very good thing in the economy. Not all deflation is due to poor or depressed demand.”
Trajtenberg continued, “European countries seeing deflation are very much a reflection of the very low level of demand in the economy and that’s not quite what we are seeing in our economy.”
In Sweden, the central bank cut its interest rate to zero. The European Central Bank, which is the central bank of the Eurozone, has already cut interest rates to 0.05%. It also continues its “quantitative easing” program, which creates extra money available to the economy by buying assets from banks. The United States, in comparison, ended their QE program last week.
Another development in the Israeli economy has been the weakening of the shekel in the previous month. The shekel was trading at 3.4 shekals to the US dollar in August, and trades at 3.8 to the dollar now. Karnit Flug, governor of the Bank of Israel, pointed to the depreciation of the shekel as a positive sign. “The depreciation is expected to improve the competitiveness of the trade sector and this will support growth.”
In simple terms, a cheaper shekel makes Israeli products attractive to foreign buyers – they literally get more for their buck. This boosts exports and brings more money into the economy. For that reason, currency depreciation is also a tool that central banks use to fight deflation. While the shekel’s depreciation is due to many factors, one of them is the Bank of Israel now holding an all time record of $87.6 billion in foreign currency reserves – the sale of shekals and purchase of foreign currency lowers the price of the shekel.
The economy in Israel is forecasted to grow by a modest 2.3% for the year 2014, according to the Bank of Israel’s projections. The International Money Fund predicts a 2.8% growth in 2015.