This year the Caesarea Forum is taking place in a period when the global economy is in a very complex situation that is reflected in its implications for Israel’s economy. Two years ago most analysts viewed the huge deficit in the US current account as the main problem facing the world economy. It was clear to everyone that the problem would be solved by the weakening of the dollar.
A year ago a very serious financial crisis erupted in the US, which spread to Canada and the advanced European economies.
That crisis has not passed yet, and it may still become even more severe. Growth is expected to slow in the US and in almost every economy in the second half of this year and in 2009, and at this stage the depth and extent of the slowdown are not clear.
When the crisis started the Federal Reserve cut the interest rate significantly, because it considered the crisis to be the most pressing issue to be dealt with, and also to help the economy get through the period of the slowdown. In Europe and the UK too the central banks focused mainly on dealing with the financial crisis and the slowdown. At present, the rise in inflation is making it necessary for the central banks to devote at least some of their attention to handling that situation.
The financial crisis has not spilled over into the emerging markets and less developed economies, and they did not experience large losses or failures of financial institutions. Nonetheless, the crisis has affected all countries, and stock markets fell, risk premiums rose, currencies strengthened against the dollar, and the expected rate of growth in 2008 and 2009 declined.
These developments were expected as soon as the crisis broke out, but the rises in world prices of food and energy were not.
The combination of high inflation and a slowdown in growth presents a challenge to central banks and governments everywhere, and Israel is certainly no exception.
In the early days of the crisis inflation was relatively low, and central banks focused essentially on dealing with the financial crisis, mainly by taking very active steps to supply liquidity. When it became apparent that the threat of inflation had grown, they adopted the flexible inflation targeting approach. In other words, in the circumstances then prevailing, they acted to return inflation gradually to the price stability range within a reasonable period. They did so because reducing inflation immediately by a sharp rise in the interest rate is likely to harm economic growth unnecessarily. The flexible inflation targeting approach is the one followed by the Bank of Israel too.
Let us turn now to the Israeli economy, which has grown rapidly, at a rate of more than 5 percent a year, since the middle of 2003. This was the result of the growth of the global economy and Israel’s very successful macroeconomic policy––a budget policy that led to a reduction of the debt burden, which is still high, and an interest rate policy directed to maintaining price stability. The rapid growth resulted in lower unemployment, a rise in the standard of living of the weaker groups in the population, an improved credit rating for the economy, an invitation to start the procedure for joining the OECD, etc.
Since July/August 2007 Israel’s economy, along with most other economies throughout the world, has been confronting the implications of the financial crisis and the