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The Bank of Israel's Monetary Program for March 2002
The Bank of Israel today announced its monetary program for March 2002, according to which its interest rate will rise by 0.6 percentage points to 4.4 percent.
The Bank of Israel explains that inflation expectations for the next few years-derived from the capital markets, private forecasters' predictions, and inflation estimations derived from the models developed in the Bank of Israel-have risen above the upper limit of the target ranges of 2-3 percent for 2002 and 1-3 percent from 2003 onwards. The rise in inflation assessments, together with the greater degree of uncertainty in the financial markets against the background of both the slack which is evident in fiscal discipline and the security situation necessitate a rise in the Bank of Israel's interest rate in order to return to an environment of price stability and to maintain financial stability. This increase in the interest rate-given the level of real interest, which is at an all-time low, and the real depreciation of the NIS to date-can continue to support growth and employment only if there is no undermining of price stability, and if financial stability, which is especially important at times of increased uncertainty, is preserved.
The Bank notes that although the CPI rose in January mainly as a result of rises in components which are more sensitive to depreciation, it is reasonable to assume that the increase was not a one-time occurrence restricted just to that month. Future developments depend on the extent to which the NIS continues to weaken and the effect of such weakening on the general price level.
The Bank adds that fiscal policy for 2002 is not carried out by a specific cut in expenditure relative to a sum previously approved by the government, but by achieving the budget deficit target of 3 percent of GDP, which will credibly lead towards the target deficit of 2 percent of GDP in 2003-targets also decided upon by the government. The scepticism regarding the government's ability to achieve this downward path for the deficit is reflected by the interest rates it must pay on bonds it has to sell to the public to finance the deficit, interest rates which determine the cost of capital for the whole economy. Nominal interest rates on unindexed government bonds did not come down despite the significant cut in the Bank of Israel's short-term interest rate, while real interest rates fell only slightly, and that was due to the rise in inflation expectations (see Table 2). The purpose of the change in economic policy announced on 23 December 2001 was to lower interest rates for all periods in order to encourage investment and boost employment. This did not happen. The Bank reiterates that it is not possible to maintain a low level of short-term interest and simultaneously maintain price stability if long-term interest does not decline or if it actually rises.
The Bank of Israel notes that the aim of the policy of lowering the budget deficit is to cut the government-debt/GDP ratio in order to reduce interest payments in the budget. This ratio rose, for the first time in many years, from 90 percent in 2000 to 96 percent in 2001, and it will continue to climb if the government does not meet the deficit targets it has set.
The change in economic policy at the end of 2001 resulted in an adjustment in the public's asset portfolio, as the NIS depreciated by 8-10 percent against the dollar. As the exchange rate rose, so did its volatility, and the standard deviation-derived from the prices of Bank of Israel options-rose from 7.0 percent to 9.0 percent. Note, however, that higher standard deviations than this are normal on foreign-currency markets abroad. The Bank of Israel adds that the rise in the exchange rate took place with a high level of trade, which indicates the market's increased sophistication.
Israel's risk premium, measured via government bonds traded abroad, edged up; it is difficult to use this as a guide to foreign investors' assessments of Israel's risk, however, due to the heavy involvement of Israeli investors in these markets and the low level of tradability.
In short, the Bank will continue to adjust the interest rate to the extent required to return the economy to, and keep it on, the path of price stability, which is an indispensable condition for sustainable growth. Only thus can low short-term real interest rates and real depreciation-which support economic growth-be maintained. The stronger the proof provided by fiscal discipline that the government is standing by its decision to revert to a downward budget-deficit path, to 3 percent of GDP in 2002 and 3 percent of GDP in 2003, the more the reduction in long-term interest rates will contribute to the attainment of the goal, and will enable lower short-term interest rates too. The openness of the financial, foreign-currency and bond markets enables the public to show continuously how it rates the success and credibility of policy in this field.
Changes in NIS and dollar interest rates
* The comparison of interest rates requires reference also to Israel's country risk, which according to international capital markets now ranges from 0.90 percent percentage point (for half a year) to 1.50 percentage points (for 10 years). Note that the risk premium is characterized by volatility which is sometimes caused by factors related to Israel's economy, by developments in financial markets abroad and by changes in the degree of tradability in those markets
The Bank of Israel Real Rate of Interest
a Calculated in annual terms.
b Calculated as the daily compound interest rate, based on the interbank rate (see explanation in BOI no. 2).
c Real rate of interest is the effective rate of interest minus inflation expectations derived from the capital market.