The Bank of Israel raises the interest rate for August 2006 by 25 basis points to 5.5 percent

The Bank of Israel raises the interest rate for August 2006 by 25 basis points to 5.5 percent
The interest rate for August 2006 will rise by 25 basis points to 5.5 percent. This decision is designed to ensure that inflation will be within the limits of the inflation target of between 1 percent and 3 percent a year.
Background conditions
In the first half of 2006 the Consumer Price Index (CPI) rose by 1.6 percent, above the upper limit of the inflation target range. The rate of inflation over the last twelve months was 3.5 percent, above the upper limit of the target range, but it is expected to return to within the range next month.
Inflation expectations for the next twelve months derived from the capital markets remained stable, close to the midpoint of the target range, and in July averaged 1.7 percent. Economic forecasters’ assessments of inflation over the next twelve months, averaging 2.3 percent, are close to the midpoint of the range, after rising by 0.6 of a percentage point due to the change in the security situation. The rise in the expected rate of inflation stems from heightened uncertainty, which raises the economy’s risk premium and acts against the forces tending to strengthen the sheqel. As a result of the tension created by the security situation, the economic forecasters also raised their assessments regarding the change in the interest rate, and estimate that the August interest rate will be raised. The capital market (the makam curve) also shows the expectation of a rise in the interest rate.
The data reflecting the state of the economy prior to the hostilities on Israel’s northern border indicated continued rapid economic growth. According to the most recent National Accounts data, GDP rose at an annual rate of 6 percent in the first quarter of 2006, with domestic demand rising at a more rapid rate. According to the Bank of Israel’s Companies Survey, which was carried out prior to the outbreak of the fighting in the North, economic activity continued expanding in the second quarter, and companies expected, with a high degree of probability, that it would carry on increasing in the third quarter. The Composite State-of-the-Economy index continued to rise at a fast pace, rising by 0.7 percent in June.
The conflict in the North makes it necessary to reassess the expected level of activity in the economy. The degree of real damage to economic activity depends on how long the current hostilities will continue and on their outcome, and the results are felt both on the supply side, the reduction of production capacity, and on the demand side, the lowering of private sector demand. A calculation performed in the Bank of Israel yields the result that, assuming a quick end to the fighting, the damage caused to economic activity will remain relatively low, up to one percent of GDP. A major element in this calculation is the harm caused to tourism.
Despite the escalation of the fighting, exchange-rate fluctuations were relatively moderate: in the first days of the hostilities in the North the exchange rate rose from 4.40 to 4.52 sheqel to the dollar, but then the NIS strengthened again. In the light of the security situation a rise in the degree of uncertainty was evident in the foreign currency market, and this was reflected by a rise in implied volatility––the probability of depreciation increased somewhat, while the probability of appreciation remained high. The Bank of Israel projects that the economy will continue to enjoy a surplus in the current account of the balance of payment.
Financial market data indicate that central banks are expected to continue monetary tightening, particularly in Europe. However, in the last few days the probability of further tightening in the US at the beginning of August declined.
Prior to the fighting in the North, it was expected that the government budget deficit in 2006 would not exceed one percent of GDP. The hostilities increase certain categories of government expenditure (defense expenditure and expenditure not covered by the damages fund) and reduce tax revenues. Nevertheless, the advantageous starting point from the aspect of the government budget will enable the budget targets set for 2006 to be met. Fiscal discipline is expected to continue, with adherence to the ceiling government deficit for 2007 of 2 percent of GDP. The government decided to maintain the maximum increase in expenditure (1.7 percent, from 2007), and to meet new expenditures from within the budget framework by changes in spending priorities. This policy will enable the government debt burden to be reduced further.
The main considerations behind the decision
  Inflation in the first half of 2006 was close to the upper limit of the target price-stability range, while viewed over the previous twelve months inflation was above the upper limit of the range. The main forces affecting inflation in the first half of the year––in particular the rise in energy prices and in prices of other imports, and the contraction of the output gap––continue to exert inflationary pressures. These forces were partly offset in the second quarter of 2006 by the strengthening of the sheqel.
  In the light of the changed security situation, Israel’s economic risk assessment increased. The rise in risk serves to reduce capital inflows and acts against the forces tending to strengthen the sheqel. This rise in risk, including inflation risk, demands a measure of monetary tightening, in order to maintain price stability and to bolster financial stability.
The Bank of Israel will continue to monitor economic developments closely with the intention of achieving the 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.