Karnit Flug: The challenges facing short- and long-term economic policy
Main point of remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Calcalist
conference "The challenges facing short-and long-term economic policy", Tel-Aviv,
30 December 2015.
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I would like to relate in these remarks to the challenges facing macroeconomic policy: monetary
policy, under the auspices of the Bank of Israel, which is focused on smoothing the short-term
effect of volatility in the economy (business cycles) on inflation and on growth and employment;
and fiscal and structural policy, which is focused on achieving inclusive growth that will support
an increase in the standard of living of the entire population over time.
Two days ago, the Bank of Israel Research Department published its macroeconomic forecast
for the coming two years, from which we can assess the trends forecast for the short term.
The growth forecast was revised downward, influenced by a further downward revision of
global growth and global trade forecasts. The forecast projects continued moderate growth of
2.8 percent in 2016, and some acceleration in the following year. Exports are expected to grow
in accordance with the global trade forecast, and private consumption is expected to moderate
slightly, following a relatively sharp increase in 2015.
This is the main scenario of the forecast. However, it is important to remember that there is
uncertainty surrounding the forecast - as there is with any forecast - as presented graphically
in the fan chart (which presents the range of projections with a likelihood of 66 percent). Some
of the uncertainty regarding growth in Israel is derived from similar uncertainty that exists in
relation to the global environment that will exist during that period. It is important to remember
that monetary policy affects inflation and growth with a lag. In other words, it is forward-looking,
and therefore, by definition, it operates under uncertainty.
Another illustration of the uncertainty, as well as the dynamism, of the environment in which
we are operating can be seen in the significant revisions of the forecasts made by the
international organizations (in this case the IMF) in relation to global growth and - even more
importantly for the Israeli economy - in relation to growth in global trade. During the past year,
the forecast for global trade was revised downward by 2 percentage points for each of the
years 2015 and 2016, which obviously has an impact on the forecast for Israeli exports, and
therefore on the growth of the economy in general.
As we know, inflation has been very low for the past two years - far below the inflation target
- and is expected to remain low during the coming year as well. Despite that, it is important to
note that the inflation target regime continues to enjoy trust, as shown in the medium and
longer-term inflation expectations. The low inflation is to a large extent the result of commodity
and energy price declines and of price reductions initiated by the government. In the past year,
these factors were responsible for a 1.7 percentage point decline in the CPI, such that the CPI
excluding these factors increased by 0.8 percent. In this context, it is important to emphasize
that monetary policy does not aim to offset such one-off factors, but rather is forward looking,
and acts to gradually return inflation to within the target range. By the way, for the coming
months, the government has already made decisions to reduce prices that together come to
0.4 percentage points of the CPI.
Another factor that has an impact on both activity and inflation is obviously the exchange rate.
The (effective) appreciation of the shekel, which is impacted by the surplus in the current
account and by the very accommodative policies of the major central banks, makes it difficult
for exports to grow under conditions where demand for Israeli exports is in any case moderate,
and acts to further moderate inflation. Our assessment is that at its current level, the shekel is
over-appreciated relative to what is in line with the basic economic forces, and we are therefore
continuing to operate in the foreign exchange market.
Against this background, the Bank of Israel has used a variety of policy tools: an
accommodative interest rate policy, together with a declaration that the Monetary Committee's
assessment is that policy is expected to remain accommodative for a considerable time,
intervention in the foreign exchange market in order to prevent an even sharper appreciation,
and a series of prudential measures to deal with the risks inherent in the housing market.
Another factor taken into account in the Bank of Israel's policy is the housing market. Home
prices that have been increasing since 2007, and with them mortgage volumes, and which
have also been affected by the low interest rate environment, are sources of concern to us
from both the financial stability aspect of borrowers' ability to repay, and the social aspect of
affordability - the economic ability of a household to provide itself with housing services. It is
therefore important to continue dealing with the problem comprehensively through a continuing
increase in the supply of homes in high-demand areas. In practice, the increase in supply
reacted with a large lag to the increase in demand. Government measures in this matter, and
a focus of efforts on shortening the planning process together with specific programs, will
contribute to change.
The monetary policy tools support economic activity in a moderating global environment, and
a return of inflation to within the target range. Accommodative monetary policy, which acts to
moderate the cyclical effects of the global environment on the Israeli economy, can enable the
government to focus its policy on the long-term challenges to achieving inclusive and
sustainable growth.
The long-term challenge - inclusive and sustainable growth
I would now like to focus on two main challenges facing the government: increasing the growth
in productivity, which will contribute to an increase in earning power and in growth; and
narrowing gaps and reducing the dimensions of poverty.
Productivity in Israel is lower than in other advanced economies. While countries with low per
capita GDP generally grow faster and reduce the gap relative to other countries, the growth in
productivity in Israel is moderate and is not narrowing the gap vis-à-vis other countries. There
are various causes of this, which the Bank of Israel has already discussed at a number of
opportunities. The low productivity is particularly prominent in the industries that focus on the
domestic market and that are not exposed to international competition - industries in which
product per work hour is low by any standard.
Earlier I presented the short-term macroeconomic forecast. In preparing the long-term
forecast, there is, obviously, greater uncertainty. The result of the simulation based on
demographic trends is worrying. The expected trends of growth in the proportion of the
population characterized by low labor force participation rates and low earning power,
alongside the aging of the population and the dissipation of the contribution of the increase in
education in the coming years, indicate that the "automatic pilot", meaning the expected
increase in GDP absent a change in policy, will reflect a marked slowdown in the projected
rate of growth. If we add to that the widespread assessment that the growth of global trade will
also be moderate in the coming years, then without a policy focused on increased productivity,
the standard of living that the Israeli economy can provide to its citizens is expected to become
more distant from that at the forefront of advanced economies.
Beyond the low productivity and its slow growth, the Israeli economy is also characterized by
high levels of inequality and poverty. Inequality in economic income - income before taxes and
transfer payments - is not exceptional by international standards. But the tax and transfer
payments policy is less active than in other countries in reducing inequality. Therefore,
inequality in disposable income - income after direct taxes (which are progressive) and transfer
payments (benefits) - is high. Inequality is not predestined. In the same way, the dimensions
of poverty in economic activity are not exceptional, but the government's policy to reduce
poverty, which is relatively modest, is reflected in a particularly high poverty rate by
international standards in terms of disposable income.
The trends I have outlined, or a low productivity growth rate, processes that are expected to
further slow future growth, together with high levels of poverty and inequality in disposable
income, bring into sharper relief the need to focus government policy on encouraging
productivity and reducing inequality and poverty.
So what can we do?
We can continue, with greater vigor, implementing (with emphasis on the term
implementing) policies to include population groups in employment (the program to reduce
gaps with the Arab community that was supposed to have been discussed by the government
included many positive components in this area); act to increase human capital - both in the
framework of the education system and through professional and technical training - in order
to increase productivity an earning power; act to remove impediments to growth, through
investment in infrastructure, improving the business environment, increasing competition in
industries where it is insufficient, promoting reforms in essential infrastructures, and supporting
R&D, including in low technology industries. There is also room to upgrade the public services,
and for adjustments in the tax system through benefits - for instance by increasing the earned
income tax credit (negative income tax), and more.
If we act decisively to implement multi-year plans, most of which exist but are
implemented sluggishly, we will be able to maximize the immense potential of the Israeli
economy for the good of all its citizens.