The Bank of Israel leaves the interest rate for July 2006 nunchanged at 5.25 percent

26.6.2006
 
The Bank of Israel leaves the interest rate for July 2006 unchanged at 5.25 percent
 
The interest rate for July 2006 will remain unchanged at 5.25 percent. The decision to leave the interest rate unchanged is consistent with the achievement of price stability within the limits of the inflation target of between 1 percent and 3 percent a year.
Background conditions
Inflation over the past 12 months reached 3.5 percent––above the upper limit of the price stability target––though inflation is expected to converge to within the target range in the coming months.
Inflation expectations for the next 12 months, derived from the capital markets, have fallen slightly and now stand close to the midpoint of the target range, or even a little below it. Forecasters also predict inflation over the next 12 months to be a little below the midpoint of the price stability target range. The Bank of Israel's own econometric models point to inflation over the next 12 months being around the midpoint of the range. At the same time, the capital market and forecasters expect the interest rate to be raised by 50 basis points by the end of the year.
According to various indicators, strong growth in the economy continues. The Bank of Israel's Composite State-of-the-Economy index shows a continued acceleration in activity, which tends to reduce the output gap and contribute to inflationary pressures. Wages in the business sector rose by some 7 percent in the 12 months to March 2006. However at this stage these increases have not resulted in rising prices, due to the rapid increase in labor productivity this year apparently as a result of the increased utilization of capital.
The exchange rate has been stable since mid-May under the influence of opposing forces from different sectors in the market. Medium- and long-term capital inflows appear likely to continue. In addition, the current account surplus of the balance of payments constitutes a basic factor that affects exchange rate developments over time. The fall in share prices in the last month likely reflects the public's wish to move into low-risk local assets which should, in itself, support a fall in domestic market interest rates.
Forecasters expect the interest rate in the US to be raised 25 basis points at the end of June.
Fiscal discipline is expected to continue and the government deficit target for 2007 has been set at 2 percent of GDP. This policy, which aims for a balanced budget in 2009, strives to reduce the burden of government debt and to maintain fiscal discipline.
The reduction of VAT by one percentage point will probably cause, directly, a 0.3-percentage point fall in the price index in the near term, but will add slightly to demand pressures and the price level over the next year and beyond.
The main considerations behind the decision
  Inflation over the past 12 months is expected to return to within the inflation target range in the next quarter. Furthermore, inflation in the next 12 months is expected to lie around the midpoint of the target range, with the markets and forecasters assuming that the interest rate will be raised by some 50 basis points by the end of the year. This development in inflation derives mainly from the continued stability in the foreign currency market.
  While inflationary pressures continue from several sources, they have on balance been offset by other factors, mainly the exchange rate. The chief inflationary factors stem from the strong growth and the reduction in the output gap, as well as the expected contraction in the interest rate differential between the NIS and the dollar. Rising business sector wages constitute an additional source of inflationary pressure, but these have been offset by the strong growth in labor productivity.
  The government's commitment to maintaining budgetary discipline which will continue to reduce the debt-to-GDP burden contributes, for its part, to local and foreign investors' positive outlook for the economy.
Consideration of these factors led to the decision to leave the interest rate unchanged this month.
The Bank of Israel will continue to monitor economic developments closely with the intention of achieving the government's price-stability target. Subject to this, the Bank will continue to support the attainment of a range of objectives of macroeconomic policy, particularly with respect to increasing employment and growth. In addition, the Bank will continue to support financial stability.