How to prevent spiral inflation

Supermarket aisle  credit: Shutterstock
Supermarket aisle credit: Shutterstock

The Bank of Israel needs to show determination in order to bring down inflation expectations, writes former governor Karnit Flug.

The Consumer Price index reading released on August 15 indicated that Israel’s inflation rate had accelerated to 5.2% for the twelve months to the end of July, a rate not seen since the global financial crisis of 2008.

The inflation is partly imported, because of disrupted supply chains and because of the war in Ukraine, which has led to rises in prices of many raw materials and in shipping costs. It also partly arises from a sharp rise in private consumption after the Covid-19 pandemic. During that period, many people saved more than they planned, as a result of restrictions on the consumption of services such as overseas travel, while now local demand for goods and services in on the rise.

Some of the factors that have led to the rise in the inflation rate can be expected to moderate shortly. The price of oil and some raw materials prices have fallen; demand for travel and vacations will decline after the summer, leading to lower prices; and the appreciation of the shekel over the past month will moderate the effect of rises in prices of imported products.

Economic policy can and should focus mainly on the inflation that stems from the heating up of the economy and surplus local demand, in order to prevent an inflationary spiral, that is, inflation that feeds inflation expectations, which it turn leads to wage increases that raise production costs, feeding back into inflation.

The main tool for dealing with demand-led inflation is monetary policy, i.e., the interest rate. The Bank of Israel has raised its rate to 1.25%, and has signaled its intention of continuing to raise rates as much as necessary, in order to restore the inflation rate to the price stability range of 1-3% annually.

To stop inflation taking root

The Bank of Israel’s policy, which aims to be "ahead of the curve", is to introduce early, fairly sharp interest rate rises to prevent inflation from taking root. The idea is to cool demand to some degree, and thereby curb inflation. To the extent that this policy is perceived by market players as backed by determination in the fight to stop inflation from becoming consolidated, it will also help in bringing down inflation expectations, and thereby help in heading off an inflationary spiral.

Alongside this, public sector pay agreements also have a role to play in preventing spiral inflation. Pay agreements should compensate for higher prices, but should be limited to compensating for past price rises, and should not be based on an assumption that high inflation will continue.

Let minimum wage rise

This, however, should not prevent the correction of distortions in existing pay agreements, and substantial corrections required in the pay of selected groups, such as young teachers. Furthermore, since the package deal did not go into effect, the temporary order preventing a rise in the minimum wage should be cancelled, and the minimum wage should be raised in accordance with the law that links it to 47.5% of the average wage. It would not be right to erode the purchasing power of the pay of the weakest groups of workers in the economy.

Implementation of the reforms that the government decided on in the last Economic Arrangements Law, designed to boost competition, could play a supporting role in halting inflation by contributing to lower prices in highly concentrated sectors. Reforms are required in industries that are not sufficiently exposed to competition from imports, whether because of protection for local producers, or unique standards, or restrictions on parallel imports, or for any other reason.

It’s important to stress that we are not where we were at the beginning of the 1980s, when inflation hit three figures. At that time, Israel had huge fiscal deficits, massive government debt, and a central bank that had to print money and finance the swelling deficits.

Today, we have responsible fiscal management, a reasonable level of government debt that is on a downward trend, and an independent central bank. Our dependence on imported energy has also declined, both because production is less energy intensive, and thanks to the natural gas found in Israel’s economic waters and the long-term agreements that secure its supply.

All the same, it’s important to deal with inflation now, so that we don’t adapt to a high inflation rate, and to prevent the formation of a spiral that will be much harder to stop.

The writer is a former governor of the Bank of Israel and is currently Vice President of Research at the Israel Democracy Institute.

Published by Globes, Israel business news - en.globes.co.il - on August 21, 2022.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2022.

Supermarket aisle  credit: Shutterstock
Supermarket aisle credit: Shutterstock
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