Changes in money supply (M1) and expected inflation for March 2003

20.04.03

The Bank of Israel will henceforth base the calculation of inflation expectations on yields on bonds before tax, instead of on yields after preliminary tax calculations

The Bank of Israel announced that in the wake of the income tax reforms, estimates of inflation expectations derived from the capital market will henceforth be based on 'gross' yields, i.e., before tax, rather than on yields after tax, 'relative-gross' yields, i.e., incorporating preliminary tax calculations, as has been the case till now. The change in the method of calculating inflation expectations is the result of the implications arising from the income tax reform, which now makes it impossible to calculate long-term expectations on a regular basis using the previous 'relative-gross' method.

As is known, inflation expectations are calculated as the difference between nominal yields (on unindexed bonds) and real yields to maturity (on indexed bonds). The Bank of Israel explained that the calculation of the 'gross' yields on indexed bonds does not take the taxation of the interest on bonds into account. This calculation of the yield is relevant for assessing its worthwhileness for two kinds of investors:

- Those who are obliged to pay tax but are exempt from deduction at source (banks, companies);

- Provident funds which are not obliged to pay tax for the period in which they held bonds.

The 'relative-gross' yield is relevant for investors who are exempt from tax (like provident funds) but are obliged to pay tax only on the relative period that elapsed between their last interest payment and the point at which they invested in bonds.

Some specific aspects of the tax reform can be noted to indicate the change in the Bank of Israel's calculation of inflation expectations according to 'gross' rather than 'relative-gross' yields.

First, as a result of the tax reform and the special exemption granted to Treasury bills for 2003, it is possible to calculate only 'gross' and not 'relative-gross' yields on these bills, which are used to estimate expectations for a year ahead. There are two reasons for this: first, the prices of Treasury bills on the stock market at the end of 2003, which serve as the base for calculating the tax that will be deducted in 2004, are not known, and no guidelines have yet been published for calculating tax on income from Treasury bills.

Second, the reform applies solely to bonds issued after May 2000 (when the recommendations for the tax reforms were submitted by the Ben-Bassat Committee). Hence, the bond market contains a mixture of bonds with differing tax statuses which are used for calculating inflation expectations for between one and ten years ahead. Thus, out of 36 series of indexed bonds (Galil) included in the calculation of inflation expectations for various terms, 33 are taxed according to the previous system and the rest according to the new one. Similarly, only two of the eight unindexed Shahar series which are used for calculating expectations for periods of over one year are still tax exempt. The number of bond series taxed according to the new system will increase over time.

The Bank of Israel noted that a comparison of the two definitions for the last 15 months shows that for the first year the 'gross' expectations are somewhat lower than the 'relative-gross' ones. These gaps are not—and will not be—constant over time, and become narrower as the estimation term grows longer. Note, too, that the Bank of Israel takes a series of relevant indicators into consideration when it comes to making its interest-rate decisions, and inflation expectations are also calculated on the basis of forecasters' predictions, for example.

 

Inflation Expectations Derived from the Capital Market, monthly average (percent)

 

Expectations for first year a

Expectations for second year b

Expectations for third year and beyond

 

Gross

Gross, relative

Gross

Gross, relative

Gross

Gross, relative

2002

           

January

2.3

2.9

1.4

1.7

2.9

2.9

February

3.0

3.1

2.2

2.7

2.7

2.7

March

2.1

2.4

2.7

3.0

2.5

2.4

April

2.5

3.4

3.2

3.2

3.1

3.2

May

3.4

4.5

3.5

3.1

3.6

3.7

June

4.5

5.0

4.7

4.1

4.7

4.5

July

2.4

2.7

3.0

2.6

3.9

3.5

August

1.7

2.0

3.1

3.1

3.8

3.8

September

2.4

3.1

3.6

3.6

4.8

4.8

October

3.0

4.0

4.9

5.0

5.9

5.9

November

2.8

3.6

4.5

4.8

5.7

5.7

December

2.2

2.8

3.8

4.2

5.4

5.3

2003

           

January

2.7

3.3

4.4

4.6

5.7

5.6

February

3.8

4.5

4.8

4.8

5.9

5.8

March

3.1

3.7

4.3

4.0

5.2

5.1

______________

a

Expectations twelve months forward. An explanation of the calculation appears in Appendix 1 in the bank of Israel's Inflation Report No. 5, for July-December 1999.

b

Based on returns on Shahar, Galil, or Sagi bonds for the same periods.

 

Changes in the M1 Money Supply and the Expected Rate of Inflation

 

 

M1 money supply

Expected inflation, monthly avg. (%)

Average monthly balance

(NIS billion)

Percentage change

Average forecast inflationb 12 months forward

Monthly
Previous 12 monthsa

December 1999

23.5

7.1

14.3

4.1

December 2000

25.3

4.8

7.5

2.5

 2001        

January

24.8

-2.0

6.5

2.2

February

25.2

1.4

11.2

2.5

March

26.0

3.5

13.9

2.5

April

26.4

1.6

12.5

2.5

May

26.5

0.1

13.7

2.2

June

26.9

1.6

13.4

2.0

July

27.7

3.0

14.9

2.0

August

28.3

2.1

16.3

2.2

September

28.9

2.3

18.5

2.7

October

28.7

-1.0

16.7

2.6

November

28.0

-2.1

16.1

1.8

December

29.2

4.1

15.3

1.6

2002

       

January

30.7

5.3

23.9

2.8

February

31.7

3.0

25.9

3.0

March

32.8

3.5

25.9

2.6

April

32.2

-1.8

21.7

2.6

May

32.6

1.3

23.2

3.4

June

32.8

0.5

21.8

3.5

July

31.8

-3.1

14.6

2.3

August

31.3

-1.3

10.8

2.0

September

31.2

-0.5

7.7

2.0

October

30.2

-3.3

5.3

2.5

November

29.8

-1.1

6.3

2.4

December

30.6

2.7

4.9

2.0

2003

       

January

31.1

1.5

1.1

2.5

February

31.2

0.3

-1.6

2.8

March c

31.6

1.2

-3.7

2.5


______________

a

The percentage change in the average level in the current month from the average level in the same month a year earlier.

b

The simple mean of inflation forecasts of the commercial banks and economic consultancy companies that publish their forecasts regularly.

c

Money supply figures are not final.

From May the Bank of Israel will only publish the gross expectation figure.