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. bis central bankers ’ speeches 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

important to recognise if there is a new normal for inflation? 30. it is important because not recognizing an upward long - term structural shift in “ normal inflation ” can lead to a flawed monetary policy stance with potentially heavy macroeconomic costs. 31. this can be understood in the paradigm of type - i and type - ii errors in statistical analysis. if indeed there is a new normal and it is not recognized, this could lead to an overtightening of monetary policy, a type - ii error. but there could be a type - i error too if the new normal is wrongly recognized and monetary conditions are kept accommodative for too long, thereby fuelling higher inflation. theory also tells us that efforts to minimize one type of error result in maximizing the other type of error. so, where should the balance lie? even if there is arguably a new normal for inflation, wouldn ’ t it be more prudent to err on the side of caution? and what will be the price to be paid for that prudence on the inflation front in terms of lost growth? 32. central banks face a complex policy choice in managing the growth - inflation balance. experience shows that policy mistakes cannot easily be reversed in short order, and typically not before heavy costs have been paid by way of welfare loss. at the same time, the probability of policy mistakes is high because it is difficult to get an accurate estimate of the potential growth rate of the economy in real time. 33. economic history of the last 50 years, especially of the us, contains several instances where central banks are alleged to have made costly errors. the best known example is the volcker disinflation policy of the early 1980s. paul volcker, the fed chairman of the time, is largely credited with restoring price stability in the us, but subsequently there have been questions about whether too high a price was paid for it by way of two recessions and a surge in unemployment. was there, in fact, a new higher normal for us inflation that volcker did not recognize? if indeed there was, how does it square with the low inflation experience of the us over the last two decades? this is a debate that is yet to be settled. 34. the importance of having an accurate estimate of the “ normal values ” of the fundamental economic variables of an economy – potential growth rate, natural rate of unemployment and threshold inflation – in order to accurately calibrate policy got reinforced bis central bankers ’ speeches recently