The Bank of Israel's Monetary Program for August 2003

28.07.03

The Bank of Israel's Monetary Program for August 2003

The Bank of Israel today announced its monetary program for August 2003, according to which the interest rate will be reduced by 0.5 percentage points to 7.0 percent.

This reduction in the interest rate was made possible despite some increase in one-year inflation expectations, against the background of the continued calm in the foreign-currency market and in the money and capital markets, and the drop in the rate of actual price rises. In the last two months, one-year inflation expectations derived from the capital market rose slightly, but remained around the middle of the government's price-stability target of 1-3 percent. Thus real short-term interest went down in this period due to the decline in nominal interest as well as the rise in inflation expectations. Inflation expectations for the second year ahead and beyond continued to decline, and are now in the upper part of the target range. Private forecasters' predictions of 12-month inflation are close to the middle of the target range, and the models developed by the Bank of Israel indicate that it is possible to attain the inflation target for the coming year and the following year while continuing to reduce the interest rate. The reduction in risk in the financial markets was reflected in the strengthening of the NIS in the last few months, that has slowed down recently, in the continued reduction of yields on unindexed long-term government bonds to below 8.0 percent, a cumulative reduction of about 4 percentage points since February 2003, and a reduction of 1.5 percentage points in the yield on 10-year indexed government bonds in that same period, to 4.4 percent. These developments may be explained mainly by the reduced regional political uncertainty following the conclusion of the war in Iraq, the confirmation of the loan guarantees by the US government, and as part of the worldwide trend of increased demand for bonds in emerging markets. Nevertheless, uncertainty still prevails, because despite the budget cuts, the deficit this year and in the next few years will be significantly higher than the path set by the government. If this scenario becomes a reality, it will prevent long-term interest from achieving its full potential reduction, which is needed to encourage investment and growth in the economy, and under certain circumstances it could constitute a source of instability.

The Bank of Israel's interest-rate policy is aimed at achieving price stability in the coming year and the next few years, in accordance with the government decision taken in 2000 which set the inflation target for 2003 and thereafter—and not necessarily for any particular calendar year—at between 1 and 3 percent (defined as price stability). In this context it should be noted that a change in the price-stability target is likely to be interpreted by the market as the first sign that the government was backing out of its commitment to price stability, and this could raise Israel's country risk premium, increase the cost of government borrowing, and make it difficult to continue the process of reducing the short-term interest rate.

Although the economic program halts the deterioration of the fiscal situation, nevertheless a government deficit of 6 percent of GDP in 2003 and of a similar size in 2004—which is high by all international standards—are inconsistent with the government decision to adhere to a downward deficit path, reducing from 3 percent of GDP in 2003 to 1 percent in 2007. The reduction in market yields reflects the public's confidence that the government will revert to a downward-sloping path for the deficit and the debt/GDP ratio. To achieve this, a decision must be made regarding a significant cut in the budget for 2004, which will be judged, in the final analysis, by the degree of its implementation. If the public assesses that the required cuts will not be carried out, the downward yield trend is likely to halt and could even change direction. Such a development would undermine the credibility of the government's ability to revert to fiscal discipline, and would itself also cause a rise in interest rates for all periods, which would damage the economy's chances of reverting to a path of growth and increased employment. Continued reductions in the short-term interest rate alongside the maintenance of price stability depends to a great extent on the government's ability to observe fiscal discipline, with a return to a downward deficit and debt path required to strengthen the financial system.

The Bank of Israel keeps a watchful eye on exchange-rate developments, and in particular analyses their implications for the inflation rate, but it is a long time since the exchange rate at any level, its trend, or its volatility have in themselves constituted targets for monetary policy. Foreign-currency markets throughout the world are highly volatile, sometimes exhibiting sharp trend reversals, and the market in Israel, which is highly developed and which offers derivative financial instruments that enable investors to contend with volatility, is similar in this respect to the international markets. Capital flows into and out of the economy are affected inter alia by interest rates in Israel and abroad, changes in which do not necessarily coincide with changes in interest rates determined by central banks. At the beginning of the year, for example, the yield spread between Israeli and US long-term government bonds contracted by more than 3 percentage points, while the differential between the interest rates of the Bank of Israel and the Fed declined by only 1 percentage point. The significance of this is that the market interest rates indicate less pressure to import capital than that reflected by the interest-rate differential between the central banks.

The Bank of Israel will continue to monitor developments in the markets, in order to ensure that the inflation rate defined as price stability is maintained while bolstering financial stability. Subject to these conditions, the Bank will act to support the government's policy to foster employment and shorten the recession.


Table 1: Interest rates in Israel and the US

End of year

Central banks' interest rates

Yield spread between US and Israel 10-year govt. bonds c

Israel

US

Differential between central banks' interest rates b

Interest ratea

Change

Interest rate

Change

1998

13.5

-

4.75

-

8.75

-

1999

11.2

-

5.50

-

5.70

-

2000

8.2

-

6.50

-

1.70

-

2001

5.8

-

1.75

-

4.05

1.6

2002

9.1

-

1.25

-

7.85

6.8

Monthly data

 
 
 
 
 
 

2002 April

4.4

0.0

1.75

-

2.65

2.9

May

4.6

0.2

1.75

-

2.85

3.9

June

7.1

2.5

1.75

-

5.35

5.5

July

9.1

2.0

1.75

-

7.35

4.7

August

9.1

0.0

1.75

-

7.35

5.1

September

9.1

0.0

1.75

-

7.35

6.6

October

9.1

0.0

1.75

-

7.35

7.8

November

9.1

0.0

1.25

-0.50

7.85

7.4

December

9.1

0.0

1.25

-

7.85

6.8

2003 January

8.9

-0.2

1.25

-

7.65

7.5

February

8.9

0.0

1.25

-

7.65

7.9

March

8.9

0.0

1.25

-

7.65

7.0

April

8.7

-0.2

1.25

-

7.45

5.6

May

8.4

-0.3

1.25

-

7.15

5.0

June

8.0

-0.4

1.25

-

6.75

4.7

July

7.5

-0.5

1.25

-0.25

6.50

4.1

August

7.0

-0.5

1.00 d

 
 
 

 

a
The rate of interest set in the previous month’s monetary program for the month indicated in the table.
b
The comparison of interest rates requires reference also to Israel’s country risk, which according to international capital markets now ranges from 1.40 percentage points (for half a year) to 1.30 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.
c
The yield spread between 10-year Shahar bonds and 10-year US government bonds.
d
The Open Market Committee of the US Federal Reserve is due to convene on 8 August 2003 for its regular review of interest-rate policy. The current Federal Reserve rate of interest, prior to the review, is
1.00 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
9-10 year bonds
d

Effectiveb

Realc

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

1.3

6.0

4.9

7.6

May

4.6

4.9

0.4

6.7

5.2

9.2

June

7.1

7.3*

*2.2

8.7

5.3

11.8

July

9.1

9.7
6.7
9.0
5.4
9.3

August

9.1

9.6
7.5
8.8
5.5
9.3

September

9.1

9.6
6.5
8.9
5.7
10.4

October

9.1

9.7
5.5 
9.3 
5.8 
11.7 

November

9.1

9.6
5.8 
8.9 
5.8 
11.5

December

9.1

9.6 
6.7 
7.9 
5.6 
10.9 

2003

 

 
 
 
 
 

January

8.9

9.4 
6.5
 8.1
5.9 
 11.4

February

8.9

9.4 
5.4
8.7 
5.8 
 11.7

March

8.9

 9.4
6.1
8.6 
5.6 
10.7

April

8.7

 9.2
7.2 
 8.2
5.4 
 9.5

May

8.4

8.8 
7.4 
7.6 
5.0 
8.5 

June

8.0

8.4 
6.8
7.1 
4.6
7.9 

July

7.5

7.9 
 6.1
6.7 
4.4 
7.9 

August

7.5

 
 
 
 
 

*
Including two increases in the interest rate in the month. The Bank of Israel's effective and real interest rates are calculated on the basis of monthly averages.
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. 2, p. 17).
c
The real rate of interest is the effective rate of interest less inflation expectations derived from the capital market.
d
Up to June 2002 the yield on 10-year auctions. From July the average daily market yield.