How to Tackle Inflation

Former Governor of the Bank of Israel Prof. Karnit Flug, explains what lies behind the recent wave of the rise in prices; what is the main tool for dealing with inflation, and how this relates to wage agreements in the public-sector. She makes is clear that we are not back where we were in the 1980s, but, we must deal with the situation without delay.

The recently published Consumer Price Index indicates a rise in the inflation rate to 5.2% over the last 12 months, higher than at any time since Israel attained price stability in 2003, with the exception of the period of the global financial crisis of 2008 (GFC)

The current rise in inflation is partially imported, with disruptions to supply chains and the war in Ukraine leading to increases in the cost of many raw materials and in shipping costs. . But it is also partially a result of a soar in private consumption, reflected in increased local demand for goods and services following the pandemic, during which many people saved more than they planned to because of restrictions on the consumption of various services such as travel abroad, vacations, visits to restaurants, and other leisure activities.

Some of the factors that have led to the rise in inflation are expected to be mitigated in the coming months: global oil prices fell in August, and there was also a decline in the cost of some raw materials around the world; demand for flights and vacations is expected to tail off after the summer months, leading to a drop in prices; and the renewed appreciation of the shekel over the last month is also expected to moderate the increase in prices of imported goods.

Thus, Israel’s economic policy can and should focus on dealing with the inflation that stems from the heating up of the local economy and surplus demand, with the aim of preventing an inflationary spiral—in which inflation fuels the expectation of further inflation, which in turn drives salary increases, thereby raising production costs, and in turn causing higher inflation, and on and on.

The main tool for dealing with demand-based inflation is monetary policy, that is, interest rate policy. The Bank of Israel has already raised its interest rate to 1.25%, and has signaled its intention to continue raising it as much as is necessary in order to ensure that inflation is driven back to the inflation target defined as price stability (between 1% and 3% per annum).

This policy of the Bank of Israel, aimed at staying ahead of the curve, entails imposing relatively sharp increases in interest rates to prevent the entrenchment of high inflation. This will lead to a certain cooling of demand in the economy, which will rein in inflation. The more this policy leads actors in the economy to view the Bank as being determined to prevent high inflation becoming the norm, the more it will help reduce expectations of higher inflation, and thus- l help prevent the creation of an inflationary spiral before it begins.

Alongside this approach, public-sector wage agreements also have a role in preventing a spiral. Wage agreements must compensate for price increases but should be short-term and focused on increases that have already occurred. It would be a mistake to sign agreements today, based on the assumption that high inflation will continue.

However, this is not to say that distortions in existing wage agreements should not be addressed. Important and necessary amendments should still be made to the wages of specific groups, such as younger teachers. Moreover, given that the agreed economic “package deal” was not implemented, the temporary order that has prevented an increase in the minimum wage should be revoked, and the minimum wage should be revised as soon as possible, in line with the law that pegs it at 47.5% of the average wage. It would be a mistake to allow erosion of the purchasing power of the salaries of Israel’s most vulnerable workers.

Another step that can help slow down inflation would be to implement the reforms the government decided on in the most recent Arrangements Law. These were intended to increase competition and lower prices in particularly centralized sectors of the economy and in those sectors not sufficiently exposed to competition from imports, whether because of protection of local producers, special regulations, restrictions on imports, or other reasons.

It is important to note that we are not where we were back in the early 1980s, when inflation reached three-digit levels. At that time, Israel had a huge budget deficit, an enormous government debt, and a central bank that was forced to print money and fund the growing deficits. Today, we have responsible budgetary management, a reasonable and declining government debt, and an independent central bank. Our dependence on imported energy has also lessened, thanks both to a decline in the energy intensity of our GDP and to the natural gas reserves discovered in our waters, and the long-term agreements that ensure supply.

At the same time, we must tackle inflation without delay, to avoid becoming accustomed to high inflation, and in order to ward off the creation of an inflationary spiral, which is much harder to halt.

A version of this article was published in Globes.