The Bank of Israel's Monetary program for June 2001

29 May 2001

Monetary program for June 2001
The Bank of Israel advises that due to continued employee sanctions and the desire to prevent a situation in which monetary policy does not respond to developments in the economy, it has decided at this stage to reduce the rate of interest for June by 0.2 percentage points, to 7.0 percent.
The Bank of Israel states that if it becomes possible to undertake an informed discussion of interest-rate policy for achieving the inflation target, either as a result of the ending of sanctions by the Bank’s employees or due the government deciding to empower the Governor of the Bank of Israel to issue certain employees with confinement orders, it may rediscuss interest-rate policy more fully in the course of June.
The Bank explains that in order to arrive at a decision regarding the rate of interest for June, various alternatives to the complete information infrastructure required for a soundly based interest-rate decision were examined. As is known, the regular infrastructure is currently lacking due to sanctions by employees which have continued for several months, and which prevented a decision regarding the rate of interest for May.
In the light of the ongoing sanctions and the fact that the government has till now not empowered the Governor to issue confinement orders which would ensure the provision of the Bank of Israel’s services to the public, including a decision on the monetary rate of interest, the bank examined various alternatives to the totality of data required. These alternatives included inflation expectations of investors in the capital market derived from government bonds, and indicators of changes in the output gap.
Inflation expectations are measured by the difference between the yield on unindexed fixed-interest bonds and that on indexed fixed-interest bonds. The raw data relating to these expectations currently place expected inflation at between one percent and two percent a year for the next six years, lower than the annual inflation target for the years 2001 and 2002, but within the target of price stability from 2003 onwards.
The assessment of inflation expectations from the capital market was in the past an important basis for decisions as to the rate of interest, but its importance declined as other methods of assessment developed, due to the fact that interest-rate decisions based on these expectations suffer from two shortcomings:
First, it became apparent that till now assessments derived from the capital market missed the turning points in inflation, both upturns and downturns. Their value in forecasting inflation, an essential aspect of every interest-rate decision, is therefore very limited. A research infrastructure was thus developed in the Bank of Israel for examining the sensitivity of future inflation to the main factors which affect it, such as capital flows and exchange rates, adherence to the budget, and actual GDP growth related to the economy’s growth potential (the output gap), all for a period of the next few years.
The second drawback of assessments of future inflation derived from the capital market is that it provides no answer to the next question required for a decision on the rate of interest: what is the expected effect of a given change in the rate of interest on future rates of inflation, given the expected changes in all the other variables mentioned above? To answer this question, too, the
Bank of Israel developed special quantitative macroeconomic models. Regarding the output gap, various indicators have suggested that in the last few months it has been a widening; research carried out in the Bank of Israel shows that the effect of this is felt after a lag, and that it can itself cause a slowdown in the rate of inflation. The Bank of Israel emphasizes that reliance on inflation expectations based on the capital market and on partial indicators of the output gap in deciding on the rate of interest is a poor and problematic substitute for basing the decision on the Bank’s complete assessment infrastructure. Only very restricted and temporary use may be made of such a method, and only with full and explicit awareness of its inherent limitations.
The Bank of Israel goes on to emphasize that neither changes in the rate of interest determined according to the inflation target nor the exchange-rate regime, provide the means for offsetting the dampening effects on Israel’s economy of factors such as the slowdown in the US, the security situation in Israel, and structural problems of specific industries and development areas.
To address this problem there is no alternative to changing the composition of government expenditure to support growth and focusing on specific areas and issues, while maintaining the downward path of the budget deficit in accordance with the government decision of August 2000. This fiscal policy must be reinforced by structural reforms, the pace of which has recently slowed significantly, also in the social sphere, and by greater transparency, including the submission of a report to the government and the public on the estimated deficit for 2001, using the internationally accepted definitions.
The Bank of Israel points out the importance of continued maintenance of the stability which has been achieved in the financial markets as a result of monetary policy, among other things. In this context the Bank of Israel notes that the exchange-rate regime, which was created under circumstances no longer applicable and which harbors the potential to cause a financial crisis of inestimable magnitude and could lead to the Bank of Israel’s superfluous and distorting intervention in the markets, must be changed.


Changes in the Interest Rates of the Central Banks of Israel and the 
US

 
 
 
ISRAEL
 
US
 
Differential 
between NIS 
and dollar 
interest rates* 
(percentage 
points) 
 
 
 Interest level (precentage annual rates)
 
 
 
 
December 
1998 
 
13.50
 
4.75
 
8.75
 
 
December 
1999 
 
11.20
 
5.50
 
5.7
 
 
December 
2000
 
8.2
 
6.5
 
1.7
 
 
Changes in interest rate in 1999 (percentage 
points)
 
 
 
 
January
 
0
 
0
 
8.75
 
 
February
 
0
 
0
 
8.75
 
 
March
 
-0.5
 
0
 
8.25
 
 
April
 
-0.5
 
0
 
7.75
 
 
May
 
-0.5
 
0
 
7.25
 
 
June
 
0
 
0.25
 
7.00
 
 
July
 
0
 
0
 
7.00
 
 
August
 
-0.5
 
0.25
 
6.25
 
 
September
 
0
 
0
 
6.25
 
 
October
 
0
 
0
 
6.25
 
 
November
 
0
 
0.25
 
6.00
 
 
December
 
-0.3
 
0
 
5.70
 
 
Changes in interest rate in 2000 (percentage 
points)
 
 
 
 
January
 
-0.5
 
0
 
5.20
 
 
February
 
-0.4
 
0.25
 
4.55
 
 
March
 
-0.4
 
0.25
 
3.90
 
 
April
 
-0.3
 
0
 
3.60
 
 
May
 
-0.3
 
0.5
 
2.80
 
 
June
 
0
 
0
 
2.80
 
 
July
 
0
 
0
 
2.80
 
 
August
 
-0.2
 
0
 
2.60
 
 
September
 
-0.2
 
0
 
2.40
 
 
October
 
-0.3
 
0
 
2.10
 
 
November
 
-0.2
 
0
 
1.9
 
 
December
 
-0.2
 
0
 
1.7
 
 
Changes in interest rate in 2001 (percentage 
points)
 
 
 
 
January 
 
-0.2
 
-0.5
 
2.0
 
 
February
 
-0.3
 
-0.5
 
2.2
 
 
March
 
-0.2
 
-0.5
 
2.5
 
 
April
 
-0.3
 
-0.5
 
2.7
 
 
May
 
0.0
 
-0.5
 
3.2
 
 
June
 
-0.2
 
 
 
 
 
 
Interest level in January 2001 (perecet, 
annual rate) 
 
 
 
 
January 
 
8.0
 
6.0
 
2.0
 
 
February
 
7.7
 
5.5
 
2.2
 
 
March
 
7.5
 
5.0
 
2.5
 
 
April
 
7.2
 
4.5
 
2.7
 
 
May
 
7.2
 
4.0
 
3.2
 
 
June**
 
7.0
 
 
 
 
 

* The comparison of interest rates requires reference also to Israel’s country risk, which according to international capital markets now ranges from 1.0 percentage point (for half a year) to 1.7 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, and sometimes by global events.
** The Open Market Committee of the US Federal Reserve is set to convene on June 27 for its regular review of interest-rate policy. The current Federal Reserve rate of interest, prior to the review, is 4.0 percent.