The Bank of Israel lowers the interest rate for November 2006 by 25 basis points to 5.25 percent

23.10.2006
 
The Bank of Israel lowers the interest rate for November 2006 by 25 basis points to 5.25 percent
 
The Bank of Israel announces that the interest rate for November 2006 will be lowered by 25 basis points to 5.25 percent. The decision to reduce the rate to 5.25 percent is consistent with the maintenance of price stability within the limits of the target range determined by the government of between one percent and three percent inflation a year over the course of time.
Background conditions
The Consumer Price Index (CPI) fell sharply in September by 0.9 percent, beyond forecasters' expectations which had ranged from a fall of 0.3 percent to a fall of 0.6 percent. This sharp drop in the CPI stems mainly from the strengthening of the shekel and a fall in the price of oil, as well as seasonal reductions in prices. The CPI has risen by 0.8 percent since the start of the year. The rate of inflation over the past twelve months is 1.3 percent, lower than the midpoint of the inflation target range.
Inflation expectations for the next twelve months and beyond, which have fluctuated close to the midpoint of the target range since January 2005 and which stood at 1.9 percent in September, fell to 1.5 percent in October, below the midpoint of the target range. Average forecasts for inflation for the next twelve months fell to 1.3 percent, while average forecasts for 2006 were adjusted downward during the month to only 0.4 percent, i.e. below the target. Private economic forecasters expect, on average, a 25 basis-point cut in the Bank of Israel interest rate for November, and a further reduction for December, which would bring the interest rate down to 5.0 percent by the end of the year. The makam curve reflects the expectations of a lower interest rate.
Data on real activity point to a rapid economic recovery after a decline in the third quarter following the fighting in the north. According to a Central Bureau of Statistics estimate published this month, GDP is expected to grow in 2006 by 4.5 percent. The Bank of Israel forecast for growth for 2007 is 4 percent. Nevertheless, there are no inflationary pressures from the labor market, as unit labor costs are on a gentle downward trend 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 investors' faith in the strength in the economy. Prior to the fighting, in July the shekel traded at about NIS 4.40 to the dollar and around the time of last month's decision on the interest rate, the exchange rate fluctuated about NIS 4.32 to the dollar, while today the shekel is trading at around NIS 4.28 to the dollar. The shekel has appreciated similarly against the basket of currencies. This strengthening of the shekel takes place against a background of a current account surplus in the balance of payments––which is expected to reach more than $ 6 billion this year––and significant inflows of foreign investment. It should be noted that the shekel's strengthening in recent months follows a period since 2002 of a real depreciation (that is depreciation adjusted for inflation gaps between Israel and abroad) of the shekel against the basket of currencies, of more than 25 percent.
In the international financial markets, Israel's risk premium, as measured by the five-year CDS spread, fell slightly. The yield gap between fixed-rate, shekel 10-year Shahar bonds and 10-year US government bonds contracted to 127 basis points from around 173 basis points in mid-September and 125 basis points prior to the war.
The US Federal Reserve left its interest rate unchanged this month at 5.25 percent. The financial markets expect no change in this rate in the coming months, followed by a reduction in the federal funds rate in the first half of 2007, though the probability the markets attach to the Fed lowering its interest rate has fallen. The European Central Bank raised its interest rate by 25 basis points this month to 3.25 percent, and the markets expect this rate to be raised to 3.5 percent by the end of the year.
Due to the cost of the hostilities in the north, a temporary increase was required in security expenditure and spending on damage compensation, to be spread over three years. This increase in expenditure is expected to raise the government deficit to around 1.5 percent of GDP this year, and the deficit ceiling approved by the government for 2007 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
  Recently, in light of the strengthening of the shekel and falling energy prices, there has been a sharp drop in the consumer price index. The rate of inflation is now close to the lower part of the inflation target range, with a high likelihood that it will fall temporarily in the coming months to below the target range. The Bank of Israel's monetary policy goal is to gradually return the inflation rate to around the midpoint of the inflation target range.
  At the present time, according to current data and the Bank of Israel's models, it is reasonable to assume that the inflationary environment will allow for a further reduction in the interest rate. This gradual reduction in the interest rate is designed to return the inflation rate to around the midpoint of the target range while avoiding shocks to the financial markets.
  Growth forecasts for 2006 reflect the assessment that the recent fighting will have no long-lasting effects on expanding economic activity nor on prices. The rate of growth in activity continues to be rapid, with GDP expected to grow by 4.5 percent in 2006 (according to the latest CBS estimate) and by around 4 percent in 2007 (according to the Bank of Israel forecast).
  There are pressures for additional budget expenditures, which contribute to some uncertainty about the fiscal situation, until the Knesset's approval of the budget for 2007.
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.