The Bank of Israel leaves the interest rate for September 2006 nunchanged at 5.5 percent

The Bank of Israel leaves the interest rate for September 2006 unchanged at 5.5 percent
The Bank of Israel announces that the interest rate for September 2006 will remain unchanged at 5.5 percent. The decision to leave the rate at its current level is consistent with the maintenance of price stability within the limits of the inflation target of between one percent and three percent inflation a year.
Background conditions
The Consumer Price Index (CPI) rose by 0.1 percent in July, slightly above forecast, and has risen by 1.7 percent since the start of the year (an annual rate of 2.2 percent, seasonally adjusted). The rate of inflation over the last twelve months fell to within the range and reached 2.5 percent.
Inflation expectations for the next twelve months and beyond, remain close to the midpoint of the target range. Expectations derived from the capital market and economic forecasters’ assessments of inflation over the next twelve months stood at the midpoint of the target range in August: at an average of between 1.9 percent and 2 percent. At the same time, some forecasters expect no further rise in the interest rate for the rest of the year, while others do foresee such a rise by the end of 2006. The makam curve reflects no change in the interest rate over the next year.
Prior to the outbreak of hostilities on Israel’s northern border, the Israeli economy was on a path of growth and GDP grew in the first half of the year at an annual rate of 5.9 percent. Data for the second half show growth in most of the major industries according to the National Accounts. According to the Employers' Survey from the Ministry of Industry, Trade and Employment, demand for labor in the business sector continued to grow and real wages have increased by 0.2 percent in the current quarter.
The damage from the fighting was concentrated in the manufacturing, commerce and services, tourism and agriculture industries. Part of the losses caused to manufacturing and the commerce and services industry could yet be set off later this year which could minimize the damage to economic growth, rendering it only temporary with most of it impacting in the third quarter. However, the rate of recovery for incoming tourism is expected to be slow. Growth forecast for 2006 is estimated at about 4.5 percent, compared to 5.5 percent before the hostilities. According to the most recent data, one notes a drop in exports of 12 percent in July as a result, inter alia, of the temporary interruption to normal activities of factories and the difficulties of haulage following the closure of Haifa Port. Numbers of incoming tourists fell after the start of hostilities, from an average daily of 5,000 at the start of July to around 3,300 after July 12.
Despite the fighting, the capital market demonstrated firmness. Changes in nominal and real yields were moderate. Moreover, the NIS continued to strengthen and appreciated nominally against the dollar by 1.1 percent in July and showed no change in August. However in July, following the fighting, there was a rise in exchange-rate risk, as derived from trade in options, although exchange-rate fluctuations moderated in August: the implied volatility of NIS/$ options traded on the Tel Aviv Stock Exchange declined in August to 8.2 percent, on average, after rising in July to 8.6 percent, compared to 7.4 percent in June.
In the international financial markets, there was a fall in Israel's risk premium in August, as measured by the CDS spread. Surveys released by foreign investment houses during the fighting stressed the Israeli economy's positive macroeconomic data and financial stability.
The US Federal Reserve decided to keep its federal funds rate unchanged, and the probability of a further rise at its next meeting is less than 50 percent, according to the financial markets. At the same time, the markets expect interest rates in the European Monetary Union to be raised 25 basis points in continuation of its monetary tightening.
Government budget performance in July was significantly different to previous months. Government domestic deficit was higher than seasonal, against a background of income levels consistent with that derived from the budget forecast and spending levels significantly higher than forecast, as a result of the fighting. The budget is therefore expected to be fully utilized this year and total income is expected to be around NIS 7 billion higher than forecast in the budget. Assuming that the hostilities will cause damage of around 1 percent of GDP, the total government deficit (net of credit) for the whole of 2006 is expected to total around 2 percent of GDP.
The main considerations behind the decision
  The rate of inflation since the start of 2006 has moderated and is now close to the midpoint of the inflation target range. Estimates from the capital market and private forecasters for the year ahead point to future developments of inflation within the inflation target range, at the current rate of interest.
  The expected damage to GDP as a result of the fighting could reduce demand in the private sector. However aggregate demand is not expected to drop significantly in light of the effect of future changes in the government budget. At the same time, the expected damage on the supply side will likely be temporary and short term. Therefore there is unlikely to be a significant impact from all these changes on prices.
  In light of the implications of the fighting it is reasonable to assume that government expenditure for 2006 and 2007 will increase, though there is uncertainty regarding the size of this increase. This expected development constitutes a further consideration in leaving the interest rate at its current level to maintain price stability.
  Despite the rise in the level of risk and uncertainty in the period of fighting, the financial markets remained stable and demonstrated impressive financial resilience, including long-term yields. The Bank of Israel's interest-rate rise last month, and the US Federal Reserve's most recent decision to leave its federal funds rate unchanged allow a differential between these rates of 25 basis points, which is a further boost to the stability of the sheqel.
  Global oil prices stabilized and even began to fall after rising about 10 percent since the start of the summer.
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.