Not so fast.

True, Israel's 1.3 percent inflation rate n the slump year of 1999 is the lowest since 0.2 percent in the slump year of 1967 (in which the economy grew by 2.3 percent) and one of the lowest in the Western world last year. However, it is worth bearing several facts in mind:

First, were it not for the relatively high inflation in 1998, inflation in 1999 would not have been as low as it was. In the second half of 1998, prices rose at an exceptionally rapid 13 percent pace (in annual terms). In the first half of 1999, prices retreated somewhat, falling at an annual rate of 0.7 percent. The second half of 1999 was free of the effects of the exogenous shocks that struck the Israeli foreign-currency market in late 1998 and the correction in early 1999. During this half-year, prices advanced by 3.5 percent. This is also the rate that the government decided to maintain in 2000-2001.

Second, mirabile dictu, it is not enough to reduce inflation to negligible levels (even assuming that this disinflation is not an exceptional, one-year event) to declare victory. Such a reduction is an essential condition, although not a sufficient one, for such a statement. Even if we dress the low Consumer Price Index in a mantle of glittering economic indicators, we may not celebrate inflation's demise. To declare the end of inflation, one needs not only inflation rates similar to those of industrialized countries (1.5-2.5 percent) but also similar interest rates (5-6 percent, as against more than 10 percent in Israel). It is no trifling task to contain inflation in any case, but it is much easier when interest rates are left very high. The real test is to force inflation to continue "behaving itself" after we loosen our grip on interest rates. It will evidently take some time for Israel to reach that phase. How much time? In this matter, there seems to be a consensus among economic officials. As a side effect of the tough monetary policy in recent years, the public has changed its portfolio of financial assets (in what the vernacular calls the "mountain of sheqalim" and the "mountain of foreign-currency credit"). These changes (described critically and at length in previous editions of Economic Outlook) mean that, even after inflation rates fall into line with those in developed countries, much time will pass before Israel's interest rates will do the same.

Holding inflation to the Western standard is no simple matter. Although we cannot express each stage of the disinflation process, from 20 percent to the current level of 2 percent, in terms of a "degree of difficulty," the current phase-the last phase before absolute price stability-is certainly not one of the easiest. Of course, one may keep interest rates very high and raise them further whenever some exogenous or endogenous event causes inflation to speed up, but such a situation, lasting many years, has and will have serious implications that will attract many expressions of condemnation, of which "the end of inflation" is not one.

Why might it be easier to reduce inflation by 4 percentage points-say, from 20 percent to 16 percent per year-than by 2 percentage points, from 4 percent to 2 percent? One reason is the "money illusion." Paul Krugman, whose articles have had a major influence on world macroeconomic thinking in recent years, claims not only that this problem makes it harder and costlier (in terms of lost product) to reduce already-low inflation than to disinflate from higher levels, but also that the economy gains less long-term utility from disinflation to levels of 0-3 percent than from disinflation beginning at a higher plateau.

In simple terms, the "money illusion" is the phenomenon in which a person who receives a 10 percent raise amidst 10 percent annual inflation is pleased while a person who gets no raise amidst zero inflation protests his terrible mistreatment, even though neither employee's wage has changed in real terms. It's a matter of simple psychology. Another name for this phenomenon is "downward price inelasticity." One may erode wages by raising them by less than the inflation rate, but at zero inflation one cannot do the same by reducing the nominal wage.

In the context of a disinflation policy, the meaning of this illusion-according to Krugman's economic school, is that low inflation (say, 2-3 percent per year) not only inflicts little damage but actually greases the economy's wheels.

The demands presented by unions in the numerous labor disputes they have declared in the past few weeks, and the way these disputes are discussed, illustrate the money-illusion problem in practical terms. Representatives of the union or of workers on a given civil-service wage scale approach the negotiating table with the declared intention of returning to the rank-and-file with achievements in hand. In the past, when inflation was 8 percent or more, one could conclude a wage accord with a 3 percent raise without straying from the policy of leaving real wages unchanged. This is because the remaining 5 percent would be covered by Cost-of-Living-Allowance agreements and "natural wage crawl". The union representatives would trumpet their accomplishments-a raise of 3 whole percent!-and Finance Ministry representatives would do the same for having kept real wages unchanged! Everyone was satisfied. When inflation verges on zero, this cannot happen. "Wage crawl" is 3-4 percent per year in the public services and even more in some wage scales. Thus, real wages are preserved even before the union representatives come to the negotiating table. Even though there is no difference between a large nominal wage increase at high inflation and no change in nominal wage at zero inflation, the "money illusion" reduces employers' flexibility and maneuvering room vis-a-vis labor's representatives and the representatives' maneuvering room vis-a-vis those who sent them. The result, at least in the foreseeable future, may be reflected in lengthier labor disputes than today's and greater difficulty in maintaining today's low inflation rate.