On February 10, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Israel.

Israel's economic fundamentals remain strong. GDP growth is solid, unemployment is low, and inflation remains firmly anchored within the 1–3 percent target range. The financial sector is in good health and the external position is strong.

However, excluding the impact of a new large-scale natural gas production, growth momentum is expected to remain moderate, as planned fiscal tightening and a further strengthening of the currency will weigh on the economy and offset, in part, the pick-up in demand in Israel's major trading partners. The economy also faces other important challenges: public debt remains high despite a noticeable decrease over the past several years; rapid house price inflation, if it persists, poses risks to financial stability; and the large employment and productivity gaps between the general Jewish population, the Ultra-Orthodox Jewish (Haredi) and Israeli-Arab communities, if sustained, could undermine the economy's long-run growth potential.

Given the still uncertain global environment, as well as the headwinds to growth from fiscal tightening and exchange rate appreciation, monetary policy should stay the course. But the Bank of Israel should respond nimbly to changes in the economic environment. A further tightening of macroprudential measures may be needed to alleviate risks of a boom-bust cycle in the housing market. On the fiscal side, the likelihood of slippages in meeting the deficit target should be minimized by firm adherence to the expenditure ceiling and full implementation of announced revenue measures. In addition, to put public debt firmly on a downward trend, further adjustment is required in 2015 and beyond, along with a strengthening of fiscal institutions. This policy mix, combined with structural reforms to boost productivity, should help alleviate appreciation pressures on the shekel and boost competitiveness.

In line with the recommendations of the 2012 Financial Sector Assessment Program (FSAP) Update, a Financial Stability Committee should be established, led by the Bank of Israel and focusing on macroprudential policies in normal times. Legal reforms aimed at strengthening the bank resolution framework should be legislated as soon as practicable.

On the structural front, concerted action is required to boost competition in the non-tradable sector, while it is imperative to promote the participation of Haredi and Israeli-Arab populations in the labor force to reduce poverty and inequality and bolster the economy's long-run productive capacity.

Executive Board Assessment²

Executive Directors welcomed the Israeli economy’s resilience through the global crisis, which has been underpinned by sound macroeconomic and financial fundamentals. They also welcomed the progress made in reducing public debt and the government’s commitment to fiscal discipline.

Directors noted that growth would continue to be moderate, but the outlook is vulnerable to external and longer-term domestic risks. Weak external demand and appreciation pressures on the shekel are a drag on growth, house prices continue to rise rapidly, public debt is high, and growth is not inclusive. Against this backdrop, Directors underscored that policies should aim at ensuring sustainable growth, preventing the build-up of imbalances, and deepening structural reforms to bolster the economy’s productive capacity and to reduce poverty and inequality.

With inflation well anchored within the target range, a still uncertain external environment, and headwinds to growth from the planned fiscal tightening and a stronger currency, Directors agreed that monetary policy should maintain the current stance. Should growth prospects improve more than anticipated, the monetary stance would need to be gradually normalized. Directors considered that the risks ensuing from rapid house price increases should be addressed through a further tightening of macroprudential measures.

Directors commended the authorities for the bold fiscal consolidation measures embedded in the 2013–14 budget. They noted that strict adherence to the expenditure ceiling and full implementation of the announced revenue measures will be necessary to meet the fiscal targets. Directors concurred that achieving the deficit targets and ensuring debt sustainability would require further fiscal adjustment in the medium term through efforts on both the expenditure and revenue fronts.

Directors considered that embedding the current fiscal rules within a fully-fledged medium-term fiscal and expenditure framework would strengthen the budgetary and fiscal institutions. Most Directors agreed that establishing an independent fiscal council would enhance the credibility and transparency of fiscal policy while a few other Directors were of the view that the current framework has served the economy well.

Directors noted that the mix of accommodative monetary and tight fiscal policies, alongside reforms aimed at boosting productivity, would alleviate appreciation pressures on the currency and improve competitiveness. In this context, Directors saw merit in the Bank of Israel continuing their program of pre-announced foreign exchange intervention, aimed at alleviating risks of appreciation pressures emanating from promising prospects of large-scale natural gas production. Directors recognized that discretionary intervention may be needed to stem excessive exchange rate volatility.

Directors welcomed the authorities’ ongoing initiatives to buttress the financial system. They underscored that progress could be expedited on the key issues identified by FSAP Update. In particular, they encouraged the authorities to establish a Financial Stability Committee with a clear mandate and operational independence, and to legislate the draft bank resolution law as soon as practicable.

Directors noted that low labor participation of the Arab-Israeli and Haredi populations exacerbates inequality and poverty concerns and would undermine the economy’s long-run growth potential. They welcomed recent reforms and encouraged the authorities to promote further the integration of these groups in the labor market.