The Bank of Israel's Monetary Program for December 2003

24.11.03

The Bank of Israel’s Monetary Program for December 2003

The Bank of Israel today announced its monetary program for December 2003, according to which the interest rate will be reduced by 0.4 percentage points to 5.2 percent. This brings the cumulative reduction in the Bank of Israel’s interest rate since December 2002 to 3.9 percentage points.

The continuation of the process of reducing the interest rate is made possible by the fact that one-year inflation expectations 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 in November, and are currently in the lower part of the target range (i.e., just above 1 percent), and expectations for the second year ahead are still in the upper part of the target range. Private forecasters’ predictions of 12-month inflation are still in the middle of the target range, and some of 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 slowly proceeding 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 interest rates, which would probably endanger financial stability, the process of economic recovery, and in the final analysis price stability itself. 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 after edging up in the months from June to August. Since the beginning of the year nominal yields have dropped by more than 4 percentage points to a level of about 7.4 percent, and real yields by more than 1.5 percentage points to a level of about 4.2 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 its framework or weakening of the determination to revert to a downward deficit path; 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.

Despite the intermittent weakening of the NIS in the foreign currency market in the last few months, there was a fall in the implied standard deviation of the options issued by the Bank of Israel to an average of about 6.5 percent in November from 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 November to 60 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, the security-related uncertainty notwithstanding.

Nonresidents’ short-term capital inflow to Israel is affected among other things by changes in interest rates in other advanced and emerging economies and not only in the US and Europe. This can be seen from Table 3: the Bank of Israel’s interest rate is currently similar to the upper level of interest rates of central banks in other advanced economies (Australia and New Zealand—5 percent), and is in the middle of the range of interest rates of central banks in emerging and other developing economies.

 

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

 

1.00
d

4.60

3.3

December

-0.4

5.2

 

 

 

 



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 70 basis points in October to 60 basis points in November.


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 9 December 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 bonds
d

 

 

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

4.7

5.8

4.4

7.6

November

5.6

5.9

4.8

5.4

4.2

7.4

December

5.2

 

 

 

 

 

 

*

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.


Table 3:    Central Banks’ Interest Rates in Several Countries, November 2003

 

Advanced countries

Interest rate (percent)

Japan

0.00

US

1.00

ECB

2.00

Norway

2.50

Canada

2.75

Sweden

2.75

UK

3.75

Australia

5.00

New Zealand

5.00

Emerging economies

 

Thailand

1.25

Taiwan

1.375

Chile

2.75

Korea

3.75

Mexico

4.30

Israel

5.20

South Africa

8.50

Brazil

19.00

Turkey

26.00

Other developing countries

 

Czech Republic

2.00

Poland

5.25

Slovenia

7.50

Hungary

9.50