The Bank of Israel's Monetary Program for November 2003

27.10.03

The Bank of Israel’s Monetary Program for November 2003

The Bank of Israel today announced its monetary program for November 2003, according to which the interest rate will be reduced by 0.5 percentage points to 5.6 percent. This brings the cumulative reduction in the Bank of Israel’s interest rate since December 2002 to 3.5 percentage points.

The continuation of the process of reducing the interest rate is called for due to the level of one-year inflation expectations which are within the price-stability target of 1-3 percent, against the background of the actual reduction in the Consumer Price Index in the last twelve months, the continued modest level of real economic activity, and the relative calm in the foreign currency, money and capital markets. The cut in the interest rate thus supports the government’s policy to encourage economic growth and boost employment, while maintaining price and financial stability.

One-year inflation expectations derived from the capital market declined slightly in October to a little below the middle of the target range (i.e., just below 2 percent), and expectations for the second year ahead and beyond are still in the upper part of the target range. Private forecasters’ predictions of 12-month inflation went down slightly, but are also in 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 interest policy is directed towards achieving price stability on an ongoing basis, and not necessarily for any particular calendar year. Any attempt to achieve the target of price stability by the end of 2003, following the fall in prices at the beginning of the year, would require rapid acceleration of inflation in the short term, with steep cuts in the interest rate, which would probably endanger price stability, financial stability and the fragile process of economic recovery. Accordingly, the Bank of Israel’s policy at all times is aimed at attaining price stability over a period of one and two years forward.

In the last few months the yields on government bonds started declining again, so that nominal yields have dropped by about 4 percentage points since the beginning of the year to a level of about 7.8 percent, and real yields by some 1.5 percentage points in that period to a level of about 4.4 percent. The reduction in long-term interest on government  bonds apparently indicates that the public considers that the (relatively large) budget deficit derives mainly from the temporary effect of the low level of economic activity in reducing government tax revenues, and that it is to a lesser degree a structural deficit constituting a long-term problem.

The reduction of the short-term interest rate per se cannot bring about the renewal of growth. A precondition is the maintenance of fiscal discipline, and indeed, the government’s budget for 2004 submitted to the Knesset indicates the start of convergence to a downward trend for the deficit and government debt, following their three-year upward trend. This, together with the reform in the labor market and the reduction in the number of foreign workers, the implementation of the plans for infrastructure investment and other steps with long-term implications related to curbing public expenditure may be expected to help buttress stability and steer the economy back to a path of growth. It is important that in the course of approving the budget there should be no whittling away at the budget framework or weakening of the determination to revert to a downward deficit path that reflects fiscal discipline; such would be likely to undermine stability and lead to a rise in nominal and real long-term yields, obstructing the process of economic recovery.

Calm continues to prevail in the foreign currency market, reflected in the implied standard deviation of the options issued by the Bank of Israel, which averaged about 6.5 percent in October compared with close to 9 percent in June. Moreover, Israel’s risk premium as measured by the 5-year credit-default-swap (CDS) market went down in October to 70 basis points, continuing the downward path that started in the first quarter of 2003. The calm in the market may be due to the US government loan guarantees and the credibility of macroeconomic policy in the eyes of the public, despite the recent rise in the level of security-related uncertainty.

The Bank of Israel monitors 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 continue acting to support the policy to foster employment and shorten the recession.

Table 1:    Interest rates in Israel and the US

 

Central banks’ interest rates

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

 

Israel

US

Differential between central banks’ interest rates
b

End of year

Change

Interest ratea

Change

Interest rate

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

0.0

4.4

-

1.75

2.65

2.9

May

0.2

4.6

-

1.75

2.85

3.9

June

2.5

7.1

-

1.75

5.35

5.5

July

2.0

9.1

-

1.75

7.35

4.7

August

0.0

9.1

-

1.75

7.35

5.1

September

0.0

9.1

-

1.75

7.35

6.6

October

0.0

9.1

-

1.75

7.35

7.8

November

0.0

9.1

-0.50

1.25

7.85

7.4

December

0.0

9.1

-

1.25

7.85

6.8

2003 January

-0.2

8.9

-

1.25

7.65

7.5

February

0.0

8.9

-

1.25

7.65

7.9

March

0.0

8.9

-

1.25

7.65

7.0

April

-0.2

8.7

-

1.25

7.45

5.6

May

-0.3

8.4

-

1.25

7.15

5.0

June

-0.4

8.0

-

1.25

6.75

4.7

July

-0.4

7.5

-0.25

1.00

6.50

4.1

August

-0.5

7.0

-

1.00

6.00

4.3

September

-0.5

6.5

-

1.00

5.50

4.0

October

-0.4

6.1

-

1.00

5.10

3.6

November

-0.5

5.6

 

1.00d

4.60

 


a

 The rate of interest set in the previous month’s monetary program for the month indicated in the table.


b

 The risk premium, as measured by the 5-year credit-default-swap (CDS) market, went down from 85 basis points in September to 70 basis points in October.


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 28 October 2003 for its regular review of interest-rate policy. The current Federal Reserve rate of interest, prior to the review, is 1.00 percent.

Table 2: The Bank of Israel Real Rate of Interest, the Yield on Treasury Bills and on Shahar Bonds, 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 bondsd

Effectiveb

Realc

2002      January

3.8

4.0

1.7

4.3

3.8

6.6

February

3.8

4.0

0.9

4.7

4.0

6.7

March

4.4

4.6

2.5

5.3

4.5

6.9

April

4.4

4.6

2.1

6.0

5.0

7.6

May

4.6

4.9

1.5

6.7

5.3

9.2

June

7.1

7.3*

2.7*

8.7

5.4

11.8

July

9.1

9.7

7.0

9.0

5.4

9.3

August

9.1

9.6

7.8

8.8

5.5

9.3

September

9.1

9.6

7.1

8.9

5.7

10.4

October

9.1

9.7

6.4

9.3

5.8

11.7

November

9.1

9.6

6.6

8.9

5.8

11.5

December

9.1

9.6

7.2

7.9

5.7

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

8.0

July

7.5

7.9

5.4

6.7

4.4

8.0

August

7.0

7.4

5.4

6.6

4.7

8.6

September

6.5

6.7

5.2

6.2

4.6

8.3

October

6.1

6.4

5.0

5.8

4.4

7.8

November

5.6

         

*

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.