Has inflation returned?

For four consecutive months – November 2008 to February 2009, there was negative inflation in Israel. All the analysts said: naturally, obviously, there's a recession developing which is causing inflation to decline. And then consumer prices increased by 0.5% in March while on 15 May, the Consumer Price Index (CPI) for April was published, showing a sharp 1% increase. Were the analysts wrong? Are there specific reasons for the strong April inflation or do the March-April consumer price increases indicate a new positive inflation trend?

The first point to make is that April inflation is traditionally high, because of seasonal factors. In the past five years (2004-2008), consumer prices increased by an average 0.9% in April. The seasonally adjusted increase in consumer prices in April 2009 was just 0.3%, compared to the 1% increase in the unadjusted index.

What are the main seasonal factors in April? One is seasonal increases in fruit and vegetable prices as new summer fruits come onto the market: in April 2009, the fruits and vegetables component of the CPI increased by 2%: in the previous three years (2006-2008), this component jumped by an average 4.4%.

Another seasonal component is clothing and footwear prices, which increased in April 2009 by 3.5%: in the years from 2000 to 2008, these prices jumped by an average 5.8 in April. Yet another seasonal element of the CPI in April is education, culture and entertainment prices: in April, these prices increased by 1.1%, identical to the average annual increase in this CPI component in the previous 4 years (2005-2008).

Besides these seasonal components, transportation prices increased by 3.3%, with a sharp 6.2% in the foreign travel sub-component (mainly as a result of the shekel devaluation in that month) and a 2.9% increase in the car purchase and maintenance sub-component (mainly as a result of the increase in fuel prices at the beginning of April).

But all this does not add up to a new positive inflationary trend, to cause concern to policy makers. In this respect, it is interesting to ask what the decision will be regarding the central bank interest rate, to be made at the end of May. The current rate of interest is 0.5%, set at the end of March. At the end of April, the Governor of the Bank of Israel decided to leave the rate unchanged, even though most analysts expected him to lower it further to 0.25%. The question now is whether Professor Stanley Fischer will again leave the rate unchanged, or – after two months of positive inflation - decide to increase it, in reaction to the inflation.

Given the clear indications of continuing recession, this is unlikely to happen. But the Governor might argue that the rate of interest is so low in any case, and a further reduction in the rate is unlikely, on its own, to make any difference to reviving economic activity. However, interest policy could be used (by raising the rate of interest) to cut off the possibility of increasing inflation.

In the context of this possibility, analysts argue that if the 2009-2010 State Budget, recently approved by the Government (see the I-Biz blog: A budget…at last) finally becomes law, it could lead to higher inflation for two main reasons: the tax increases built into the budget and the agreed-to 3% increase of government expenditure, instead of the original intention to increase expenditure by just 1.7%.

Who knows: it could well be that inflation, instead of turning out to be just a reaction to declining activity, could turn out to be a major topic of economic discussion in the months ahead.