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The Bank of Israel increases the interest rate for February 2011 by 0.25 percentage points to 2.25 percent
Background conditions
Inflation data: The December CPI rose by 0.4 percent, the upper bound of the range of forecasters' predictions. Inflation in 2010 was 2.7 percent, within the range of the price stability target. Excluding the housing component, the CPI increased by 1.9 percent in 2010.
Inflation and interest rate forecasts: The average of forecasters' inflation expectations for the next twelve monthly CPIs increased slightly to 3 percent, the upper limit of the target inflation range. Expectations calculated from the capital market also increased, and since the beginning of January this year have averaged 3.2 percent, above the upper limit of the inflation target range. Inflation measured over the previous twelve months is expected to be above the upper limit of the target inflation range for most of 2011, and to return to within the range towards the end of the year. The average of the forecasters' predictions is that the interest rate in a year's time will be 3.3 percent. Most forecasters expect the Bank of Israel to increase the interest rate for February 2011.
Real economic activity: Economic data published this month indicate that the positive trend in most sectors continued. Companies returns to the Bank of Israel Companies Survey show that business activity continued in the fourth quarter of 2010 at a similar rate to that since the beginning of the year, and the trend was expected to persist in the first quarter of 2011. The estimates of the Central Bureau of Statistics (CBS) indicate GDP growth of 4.5 percent in 2010. The composite state-of-the-economy index for December increased by a buoyant 0.7 percent, and the indices for the four previous months were all revised upwards. Exports increased by 3.1 percent in December, and imports by 5.0 percent. The Bank of Israel Research Department index of the probability of a slowdown, based on Google searches, shows an acceleration in domestic demand towards the end of 2010, and the probability of a slowdown remains below 50 percent.
The Bank of Israel staff forecast is that inflation in 2011 will be 2.6 percent, with a gradual increase in the interest rate to about 3.3 percent in the last quarter of the year. The main risks to real activity and inflation in Israel derive from developments abroad and in the local housing market.
The labor market and wages: The labor market continues to be the source of positive data, indicating ongoing improvement in that area. The CBS survey of vacancies shows a drop of 2.1 percent in December from the number in November. The average real wage per employee post increased by 3.3 percent in October compared with the level in September, and the nominal wage by 3.7 percent (both seasonally adjusted); in MayOctober 2010 the real and nominal wage per employee post increased by 3.8 percent and 1.4 percent respectively compared with their levels in the same six-month period a year earlier. It should be noted that the wage agreements signed recently in the public sector, and those due to be signed during the year, are likely to constitute another factor tending to increase wages. Preliminary data on health tax revenue in December point to a continued rapid increase in total wage payments.
Budget data: The government deficit (excluding credit) in 2010 totaled NIS 30.2 billion, 3.7 percent of GDP. The deficit in December alone was NIS 12.6 billion due to high expenditure in excess of the usual seasonal increase. Total tax revenues in 2010 were NIS 195.4 billion; after accounting for the effects of legislative changes and nonrecurring receipts this represents a real increase of 7.5 percent from the level in 2009.
The foreign exchange market: From the previous monetary policy discussion held on December 26 until January 21, the shekel depreciated by 2.8 percent in terms of the nominal effective exchange rate. The measures relating to the foreign currency market announced by the Bank of Israel last week weakened the shekel, and in the period December 26 to January 21 it depreciated by 0.7 percent against the dollar. Against the euro the shekel depreciated by 5 percent, in line with the changes in the major currencies.
The capital and money markets: Between the monetary policy discussions of December 26 and January 21, the Tel Aviv 25 index increased by 2.3 percent. In this period stock markets around the world showed a mixed trend. In Israel yields on local currency government bonds increased by between 10 and 15 basis points (b.p.) along the entire curve, similar to the worldwide trend. Yields on CPI-indexed bonds, however, dropped along the whole curve (as the slope steepened), against the background of the increase in inflation expectations. The makam yield curve showed a mixed trend as the curve became steeper, with a decline in yields of up to 20 b.p. for terms up to three months, and increases of up to 10 b.p. in yields for other terms. During the period, renewed activity by nonresidents was evident, with an increase in the daily volume of trade and sharp drops in short yields. Following the Bank of Israel's measures announced last week relating to the foreign currency market, the decline in yields moderated significantly. The yield gap between Israeli and US unindexed 10-year government bonds widened this month to 143 b.p. from 128 b.p. in the previous month, mainly due to the greater increase in yields on Israeli government bonds. In the corporate bond market the Tel-Bond 20 index rose by 2 percent, and the Tel-Bond 40 index by 2.2 percent. Israel's sovereign risk premium as measured by the five-year CDS spread declined slightly this month, to 115 b.p.
The money supply: The M1 monetary aggregate (cash held by the public and demand deposits) increased by 2.3 percent in December, following its 1.5 percent decline in November. In the whole of 2010 the M1 aggregate increased by 4.1 percent. The M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 1.9 percent in December, following its 0.9 percent increase in November; in the year 2010 it increased by 3.3 percent.
The credit market:Total outstanding business sector credit increased by 0.9 percent in November, to NIS 755 billion; half of the increase derived from the depreciation of the shekel against the dollar. From January to November 2010 this credit grew by 2.5 percent. Outstanding credit to households increased by 9.4 percent in JanuaryNovember 2010. The outstanding balance of housing loans in November 2010 was 10 percent higher than at the end of 2009. Of the total housing credit advanced in December, 47 percent was unindexed at floating interest rates, compared with the monthly average of 50.4 percent in the whole of 2010.
The housing market: House priceswhich are presented in the Central Bureau of Statistics survey of house prices and which are not included in the CPIincreased in OctoberNovember at a rate of 1.4 percent a month, following their increase of 0.4 percent in SeptemberOctober. In 2010 house prices increased by 17.3 percent. The housing price index, which is based mainly on renewed rental contracts and which is included in the CPI, rose by 0.3 percent in December, after remaining unchanged in November. The housing price index increased by 4.9 percent in 2010 as a whole.
The global economy: The most recent macroeconomic data relating to the global economy, and in particular to the US and China, indicate that the recovery from the crisis is becoming firmer. Nevertheless, high rates of unemployment and low rates of growth in the advanced economies continue to temper the general optimism. Concerns related to the European debt crisis eased slightly in light of several successful bond issues by some of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain). The need to borrow on a large scale in some of those countries in the coming year and the uncertainty in the European markets are expected to keep the situation in Europe the focus of attention in the global economy in the near future. Inflation in the US remained low, while in the eurozone inflation exceeded the target this month. In light of that development the expected timing of an increase in the interest rate in Europe was brought forward a little. Inflationary pressures continue to mount in the emerging market economies, deriving from the steep increases in commodity prices in general, and food prices in particular. Those increases give rise to concern over possible contractionary measures that could hold back global growth.
The main considerations behind the decision
The decision to increase the interest rate for February by 25 basis points to 2.25 percent is consistent with the gradual process of returning the interest rate to a more normal level intended to position inflation firmly within the target range, and to support the further recovery of economic activity, while maintaining financial stability. The rate of increase in the interest rate is not pre-determined, but is set in accordance with the inflation environment, growth in Israel and globally, the monetary policies of the leading central banks, and developments in the exchange rates of the shekel. At the current level of the interest rate, monetary policy continues to be expansionary.
  Inflation in the last twelve months was within the target range. Inflation expectations of forecasters for one year ahead are at the upper limit of the target range, and those derived from the capital market are above it. The Bank of Israel Research Department staff forecast, however, is that inflation will be 2.6 percent in 2011. These forecasts are based on expectations that the interest rate will be increased. Inflation measured over the previous twelve months is expected to be above the upper limit of the target inflation range for most of 2011, and to return to within the range towards the end of the year.
  The acceleration in house prices was renewed last month, and in the last twelve months they have risen by 17.3 percent. The volume of new housing loans increased steeply in December. The outstanding balance of housing loans in November 2010 was 10 percent higher than that at the end of 2009.
  Up-to-date economic indicators and data show that the rapid growth in the first three quarters of 2010 continued in the fourth quarter. Growth was evident in most areas of economic activity, and is expected to continue in the first quarter of 2011. Recently published data indicate that the global economy is continuing along the path of recovery from the economic crisis.
  The decision to increase the interest rate was taken despite the fact that interest rates of the central banks in the major advanced economies are at low levels and are not expected to rise in the near future. Nevertheless, some central banks in economies that are already showing relatively fast rates of growth continued the process of raising their interest rates again last month. Against this background, the amendment issued last week by the Bank of Israel to the liquidity directive contributed to a weakening of the shekel and is also expected to moderate the effect of the increase in the interest rate differentials on the strengthening of the shekel.
The Bank of Israel will continue to monitor developments in Israel's economy and the global economy and in the financial markets. The Bank will use the instruments available to it to achieve its objectives of price stability, the encouragement of employment and growth, and support for the stability of the financial system, including keeping a close watch on developments in the assets market, and especially in the housing market.
The minutes of the discussions prior to the above interest rate decision will be published on February 7, 2011.
The decision regarding the interest rate for March 2011 will be published at 17:30 on Monday, February 21, 2011.