The Bank of Israel's Monetary Program for June 2002

27.05.02

 

The Bank of Israel's Monetary Program for June 2002

The Bank of Israel today announced its monetary program for June 2002, according to which its interest rate will be raised by 1 percent to 5.6 percent.

The Bank of Israel explains that the rise in the short-term interest rate is essential to restore the development of inflation to the realm of price stability, and in order to bolster financial stability in the context of increased uncertainty following the ongoing relaxation of budgetary discipline, the increase in long-term interest, and the security incidents. The interest-rate hike is made necessary by the acceleration of inflation expectations for the next few years-as derived from the capital market, private forecasters, and the Bank of Israel's models-beyond the 3 percent rate which constitutes the upper limit of the range defined as price stability.

As will be recalled, the Bank of Israel reduced the interest rate by 2 percentage points at the end of 2001 within the framework of a program involving a change in the overall economic policy mix, and in which the government decided to return to a policy of fiscal restraint and a declining path for the deficit and the public debt in the next few years. The avowed intention of the policymakers was that this policy should also lead to the lowering of the long-term interest rate, thereby serving to stimulate economic growth and employment without imperiling price stability. This was in addition to the structural changes in the money and foreign-currency markets agreed upon within that framework, ad which were intended in themselves to make it enable price stability to be maintained with a lower interest rate. Additional important components of that program were supposed to have been an understanding with the General Federation of Labor (Histadrut) about changing the path of wages in the public services to bring it into line with price stability, and dealing with the problem of private legislation in a framework consistent with national priorities.

The assessment of the Bank of Israel-assuming that the program would be implemented in full-was that once the public's assets and liabilities portfolio had been adjusted, alongside some local-currency depreciation and a far lower one-off price increase, the foreign-currency market would stabilize and the inflation rate revert to within the range of the long-term target. In this way, real short-term interest should have declined and there should have been real depreciation-factors which serve to boost employment and growth. Depreciation did in fact halt towards the middle of February 2002, in the wake of the Bank of Israel's assertion of its determination to act to maintain price stability and reminder to the public of the risks inherent in exchange-rate-indexed investments, followed by the 0.6 percentage-point interest-rate hike at the end of February.

Due to the continued laxness of the government's fiscal policy and the deterioration of the security situation, however, the stability of the financial markets has been undermined of late, inflation expectations have risen beyond the range of the target defined as price stability, and there are apprehensions of continued local-currency depreciation and the exacerbation of these negative processes. Moreover, the interest rate on long-term Treasury bonds, which constitute a benchmark for long-term and mortgage interest rates in Israel, rose once more by more than one percentage point-outstripping their level at the end of 2001-and the interest-rate spread from unindexed 10-year Treasury bonds to short-term interest rates widened at the end of May to over 4 percent (about 9 percent in issues of Shahar, compared with less than 5 percent on short-term interest). This increase is connected with the lack of confidence in the government's ability to maintain fiscal discipline in the long run, and is directly affected by the increase in government borrowing needs in order to finance the rise in the deficit, leading to a rise in the public debt and its future debt-service. The Bank of Israel reiterates its view that in the wake of the rise in interest rates in the capital market it is unable to maintain the low level of short-term interest without resorting to ‘printing money,' doing so at an ever-increasing rate, which would ultimately be expressed in the acceleration of inflation.

Referring to the government's recent decision to amend the budget, the Bank of Israel pointed out that the main aim of macroeconomic policy is to stop the rise in unemployment and help restore the economy to a path of sustainable growth. Consequently, neither the continued expansion of the deficit, which causes long-term interest to rise and investment to be suppressed, nor an increase in the tax burden can be countenanced. Instead, adjustments and reductions should be made in the extent of the government's current expenditure, including bringing public-sector wage changes into line with a low-inflation environment. Thus, in the absence of an appropriate budget cut and acceptance of a deficit of 4 percent of GDP (which, according to cautious estimates and as measured in accordance with internationally-accepted definitions, will exceed 6 percent), it is necessary at this point to adjust monetary policy. Note that even after the interest-rate hike, real short-term interest rates will be lower than those that prevailed in the last few years and, together with the containment of the erosion due to real depreciation, monetary policy will serve to stimulate investment, employment, and growth.

Israel's risk premium, as reflected in the yield on Israel government bonds traded abroad, dipped slightly after rising in May. It is difficult to draw conclusions from this regarding the risk premium, due to the involvement of Israeli investors and the low tradability in this market. Note that the possibility of lowering Israel's credit rating was mooted by one of the rating companies, which reduced Israel's rating outlook in May. This was due mainly to Israel's fiscal weakness against the background of the deterioration in the security situation, and could increase the cost of net borrowing by the government and the private sector, serving to reduce foreign investment in Israel.

The Bank of Israel calls on the Knesset to carefully consider the proposed amendment to the Bank of Israel Law that was brought before the House at the beginning of the month. The Bank is in favor of establishing a professional Monetary Policy Council which is unbiased and not subject to conflicts of interest, but the proposed law does not guarantee this. Furthermore, the proposal will bring inflation back, undermine financial stability, constitute a retreat from the government's commitment to foreign-currency liberalization, and prevent the central bank from acting independently to attain price stability. In this context, the Bank of Israel explains, adopting the law in its present form will have a deleterious effect on Israel's country rating in the long run, causing it to be classified among those countries whose economic future is questionable and from which it is advisable to remain as far away as possible.


Changes in NIS and dollar interest rates

 

 

 

ISRAEL

 

US

Differential between NIS and dollar interest rates*

(percentage points)

Interest level (percent, annual rate)

 

December 2000

8.20

6.50

1.70

December 2001

5.80

1.75

4.05

Changes in interest rate percentage points)

 

2001      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

-0.4

-

2.8

July

-0.3

-0.25

2.75

August

-0.2

-0.25

2.80

September

0.0

-0.50

3.30

October

0.0

-0.50

3.80

November

-0.2

-0.50

4.10

December

-0.3

-0.25

4.05

2002      January

-2.0

-

2.05

February

0.0

-

2.05

March

0.6

-

2.65

April

0.0

-

2.65

May

0.2

-

2.85

June

1.0

-

3.85

Interest level (percent, annual rate)

 

2001      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

6.8

4.0

2.8

July

6.5

3.75

2.75

August

6.3

3.5

2.80

September

6.3

3.0

3.30

October

6.3

2.5

3.80

November

6.1

2.0

4.10

December

5.8

1.75

4.05

2002      January

3.8

1.75

2.05

February

3.8

1.75

2.05

March

4.4

1.75

2.65

April

0.0

1.75

2.65

May

4.6

1.75

2.85

June

5.6

1.75**

3.85

*  The comparison of interest rates requires reference also to Israel's country risk, which according to international capital markets now ranges from 0.95 percentage points (for half a year) to 1.40 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 Open Market Committee of the US Federal Reserve is due to convene on 26 June 2002 for its regular review of interest-rate policy. The current Federal Reserve rate of interest, prior to the review, is
1.75 percent.

 

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)

    

Headline rate (simple)a

Bank of Israel rate of interest

Yield on 12-month Treasury bills

Real yield to redemption on CPI-indexed 10-year bonds

Yield on Shahar unindexed fixed-rate 10-year bonds

Effectiveb

Realc

2000                  

April

9.6

10.1

7.0

8.8

5.1

-

May

9.3

9.9

6.0

9.1

5.1

-

June

9.3

9.9

6.1

9.3

5.2

-

July

9.3

9.8

7.1

9.0

5.4

-

August

9.1

9.6

7.3

8.8

5.6

-

September

8.9

9.4

6.9

8.7

5.7

-

October

8.6

9.1

6.9

8.6

5.6

-

November

8.4

8.9

7.0

8.4

5.6

-

December

8.2

8.6

7.8

7.8

5.8

-

2001                  

 January

8.0

8.4

7.0

7.6

5.6

-

February

7.7

8.1

6.0

7.3

5.3

-

March

7.5

7.9

5.8

7.1

5.1

-

April

7.2

7.6

6.2

6.8

5.0

-

May

7.2

7.6

6.3

6.6

4.7

6.6

June

6.8

7.3

5.5

6.4

4.3

6.5

July

6.5

6.8

4.6

6.2

4.4

6.8

August

6.3

6.6

3.6

6.4

4.5

7.4

September

6.3

6.6

2.9

6.7

4.6

8.1

October

6.3

6.6

4.1

6.3

4.7

7.3

November

6.1

6.4

5.0

5.8

4.7

6.9

December

5.8

5.6

4.0

5.0

4.3

6.7

2002                  

 January

3.8

4.0

1.2

4.3

3.7

6.6

February

3.8

4.0

0.8

4.7

3.9

6.7

March

4.4

4.6

2.2

5.3

4.4

6.9

April

4.4

4.6

1.4

5.7

4.9

7.6

May

4.6

4.8

0.5

6.5

5.2

9.2

June

5.6

         

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.