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

The Bank of Israel leaves the interest rate for October 2006 unchanged at 5.5 percent
The Bank of Israel announces that the interest rate for October 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 target determined by the government of between one percent and three percent inflation a year.
Background conditions
The Consumer Price Index (CPI) remained unchanged in August, similar to forecasters' expectations, and has risen by 1.7 percent since the start of the year. The rate of inflation over the past twelve months is 2.2 percent, consistent with the necessary path for meeting the inflation target.
Inflation expectations for the next twelve months and beyond remain close to the midpoint of the target range. Average forecasts for inflation for 2006 stand at 1.8 percent. Some private economic forecasters expect no further rise in the interest rate for the rest of the year, while others do foresee a modest rise by the end of 2006. The makam curve reflects no significant change in the interest rate over the next year.
Data on real activity point to a rapid economic recovery after a drop in activity in the third quarter following the fighting in the north. 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 5.7 percent, while the business sector grew by 7.5 percent. According to the latest Bank of Israel forecasts, GDP is expected to grow by 4 percent in 2006 (compared to 5.4 percent without the effect of the fighting). Growth forecast for 2007 is estimated at 4 percent (similar to the forecast prior to the fighting, of 3.9 percent). The unemployment rate rose slightly in the second quarter of 2006 from 8.8 percent to 8.9 percent following an increase in the participation rate of the population in the workforce. There are no inflationary pressures from the labor market as during the first half of 2006 unit labor costs continued to fall against a background of rapidly rising productivity.
The stability of the financial markets and the firmness of the shekel in the foreign exchange market throughout the period of fighting––except for the initial few days––and afterward point to the strength of the economy. This stability also reflects the assessment that the effect of the fighting will be relatively modest. The changes in nominal and real yields were moderate. Moreover, the shekel continued to strengthen. Prior to the fighting, in July the shekel traded at around NIS 4.40 to the dollar while in recent days, the exchange rate has fluctuated around NIS 4.32 to the dollar. The shekel appreciated similarly against the basket of currencies. Furthermore, the current account of the balance of payments continues to report a surplus.
In the international financial markets, Israel's risk premium, as measured by the CDS spread, remained steady. However the yield gap between fixed-rate, shekel 10-year Shahar bonds and similarly termed US government bonds expanded to around 170 basis points, compared to a gap of 125 basis points prior to the fighting.
The financial markets do not expect the US Federal Reserve to change its interest rate before the end of the year––i.e. that the federal funds rate will remain at its current level of 5.25 percent––but do expect the Fed to lower its rate at the beginning of 2007. At the same time, the markets expect that the European Central Bank's interest rate, currently at 3 percent, will be raised to 3.5 percent by the end of the year.
Due to the cost of the hostilities in the north, a one-time increase was required in security expenditure and spending on damage compensation, of around NIS 13.5 billion. This increase in expenditure is expected to raise the government deficit to 2 percent of GDP this year, and the deficit ceiling for 2007––approved two weeks ago by the government––stands at 2.9 percent of GDP. The proposed government budget is expected to be submitted for approval by the Knesset.
The main considerations behind the decision
  The rate of inflation 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.
  Assuming the proposed government budget for 2007 is approved by the Knesset and there are no geopolitical changes, the effects of the fighting are not expected to be long lasting on the future expansion of economic activity nor on prices.
  Up to now, the financial markets have demonstrated relative stability. The shekel has recently strengthened further in the foreign exchange market.
  In the past two months, global oil prices fell in a volatile market, while rising oil prices at the beginning of the year contributed to a rise in the inflation rate.
  However there remains some uncertainty regarding the debate on the state budget for 2007 during the Knesset's discussion on its approval, and this could last for months. It is important that the government budget be adopted soon by the Knesset in order to shorten the period of uncertainty, particularly in light of the high ratio of public debt to GDP. This is important in order to keep on a path of growth, based on price stability, that was the situation prior to the fighting, and to improve the chances of making such a situation sustainable.
The decision to leave the interest rate unchanged in October took into account all these considerations with the intention of maintaining price 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.