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The Bank of Israel's Monetary Program for May 2002
The Bank of Israel today announced its monetary program for May 2002, according to which its interest rate will be raised by 0.2 percentage points to 4.6 percent.
The Bank of Israel explains that the rise in the interest rate is intended to restrict the insinuation of the rise in prices in the last few months into an ongoing increase in the rate of inflation for next year to over 3 percent, the upper limit of the long-term target. The decision was taken in the light of the rise in the last month of expected inflation over the next few years; the increase in the budget deficit which is likely to deviate significantly again this year from the norm in advanced countries, and which will continue to increase the public debt; the concern that depreciation of the NIS may continue, with its implications for the rate of inflation; the surge in the money supply and the rise in the liquid part of the public's asset portfolio; the rise in interest rates in the money and capital markets due to the increase in the budget deficit and in the level of uncertainty; and the recent deterioration in foreign investors' and rating companies' assessment of Israel's economy.
The Bank of Israel stresses that monetary policy aims to maintain price stability as an essential element of sustainable growth, as well as to reinforce the financial stability of the money, capital, and foreign-exchange markets. This stability, which contributes to Israel's economic robustness, requires adherence to fiscal and monetary discipline.
Although inflation assessments for the next few years obtained from inflation expectations in the capital market, private forecasters' assessments, and inflation estimates based on models developed in the Bank of Israel indicated a decline in March into the target range, they have risen from the beginning of April to date and are above the long-term target range. The Bank also notes that these assessments, which are derived from the rise in the exchange rate in the last month, among other things, all assume that the Bank's interest rate will rise during the year and prevent inflation from reaching higher levels. In addition, the change in the money supply, which increased by 26.4 percent in 2001, as well as the rise in the liquid components of the public's asset portfolio, indicate a higher level of uncertainty and the possibility that this money may be diverted into other channels, a move which could translate into a rapid rise of the exchange rate, and which would eventually become a higher rate of inflation.
The Bank explains that in 2002, too, the government deficit is expected to be higher than planned, even if the entire change in the budget which has yet to be approved is passed. The size of the deficit is beyond that considered acceptable in the advanced countries (even using to Israel's specific lenient definition of the deficit), and will oblige the government to increase its borrowing to finance it, which will result in a rise in the rate of interest it will have to pay on its debt. In April interest rates on unindexed 10-year government bonds rose to 7.6 percent, about one percentage point higher than at the beginning of the year, and interest on indexed debt rose by a similar amount in that period to 4.8 percent. The increases in these interest rates cause a parallel rise in other interest rates and depress investment and employment. The budget deficit is also reflected in the interest on one-year Treasury bills, which rose from 1.5 percent at the beginning of the year to 5.7 percent; in the light of these rises in all interest rates in the capital market, the Bank of Israel is unable to maintain the short-term interest rates which it sets other than by printing money at an ever faster rate, which is already reflected in the rapid rise in the money supply, and which would eventually boost the rate of inflation.
The Bank also explains that even in an economy experiencing a recession a situation could arise in which prices start rising again and stability becomes undermined. Although the threat of price rises in an economy in recession is somewhat less acute, accepting an increase in the rate of inflation is likely to lead the economy into the unfortunate combination of inflation and high unemployment. In this context it is relevant to note that the Bank of Israel's short-term real rate of interest since the beginning of 2000 was 1.5 percent, its lowest level for 8 years, and the Bank's policy thus supports the government's policy of stimulating growth and employment.
Israel's risk premium as reflected in the yield on Israel government bonds traded abroad rose for both the short term (by 35 basis points, to 1.15 percentage points) and the long term (by 25 basis points, to 1.65 percentage points). This rise, despite the difficulty in drawing conclusions regarding the risk premium due to the involvement of Israeli investors and the low tradability in this market, do indicate an increase in uncertainty regarding Israel's economy. It should also be noted that for the first time since external companies started rating Israel's economy, one of the rating companies has recorded a negative change in its assessment, due mainly to Israel's fiscal weakness against the background of the deterioration in the security situation.
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 1.15 percentage points (for half a year) to 1.65 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.
Open Market Committee of the US Federal Reserve is due to convene on
7 May 2002 for its regular review of interest-rate policy. The current
Federal Reserve rate of interest, prior to the review, is
The Bank of Israel Real Rate of Interest, the Yield on Treasury Bills, and the Real Yield on CPI-Indexed Government Bonds
(monthly average, percent)
a Announced interest rate in simple annual terms (excluding compound interest).
b Calculated as the daily compound interest rate, based on the interbank rate (see explanation in BOI no. 6).
c The real rate of interest is the effective rate of interest less inflation expectations derived from the capital market.