The Bank of Israel lowers the interest rate for December 2006 by 25 basis points to 5 percent

The Bank of Israel lowers the interest rate for December 2006 by 25 basis points to 5 percent
The Bank of Israel announces that the interest rate for December 2006 will be lowered by 25 basis points to 5 percent. This step is consistent with the policy of maintaining price stability in the long run, in accordance with the inflation target of
1–3 percent a year.
Background conditions
The Consumer Price Index (CPI) fell in October by 0.7 percent, in excess of the fall expected by private forecasters of between 0.2 percent and 0.5 percent. This drop in the CPI stems mainly from the continued strengthening of the shekel and the fall in housing prices and in the world price of oil. The CPI has risen by 0.1 percent since the start of the year, and in the last twelve months it has declined by 0.2 percent, below the lower limit of the target inflation range.
Inflation expectations for the next twelve months derived from the capital market remained in the vicinity of the midpoint of the target inflation range from January 2005 to September 2006. In October and November, however, they were about 1.5 percent, below the midpoint of the range. This is in line with assessments derived from the yield curve of a reduction in the interest rate of 0.5 of a percentage point in the course of the next twelve months. On the other hand, the forecasters predict inflation for the next twelve months at close to the midpoint of the range, at 2.1 percent, and expect, on average, that the Bank of Israel interest rate will be cut and that it will settle at 5.0 percent in 2007.
National Accounts data for the third quarter indicate a fall of 1.4 percent in GDP, in annual terms (seasonally adjusted). Most of the decline reflects a 20 percent drop in exports, whereas at the same time investment in the principal industries rose by some 22 percent. The extent of the impact on GDP in the third quarter was less than that expected by the Bank of Israel, and it now appears that the rate of growth in 2006 will be 4.8 percent, slightly higher than that forecast by the Bank immediately after the hostilities in the north. Foreign trade data for October show continued export and import growth, with a contraction in the trade deficit. At the same time the composite state-of-the-economy index rose by 0.6 percent, and the figures of tourist entries indicate that tourism has stopped declining. All the above paint a picture of rapid recovery from the impact on activity in the third quarter caused by the war.
Nonresidents’ flow of investments in Israel continued unabated in October, following the trend set earlier in the year. The flow of foreign investment, together with the current account surplus in the balance of payments––which is expected to reach more than $ 6 billion this year––provide the background to the strengthening of the shekel to date.
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, 10-year Shahar local-currency bonds and 10-year US government bonds contracted to about 1.3 percentage points.
Data of the performance of the government budget in October show a marked recovery in tax revenues, and that since May expenditure is settling at a high level. The Bank of Israel assessments are that expenditure in 2006 will exceed the original budget by some NIS 3 billion, and the revenues will be about NIS 10 billion higher than the budget forecast. The deficit is therefore expected to reach 1.8 percent of GDP.
The main considerations behind the decision
  Due to the strengthening of the shekel and falling energy prices, the annual rate of inflation is below the target range. The Bank of Israel has therefore decided to cut the interest rate by 25 basis points, to 5 percent, with the intention of gradually bringing the inflation rate to around the midpoint of the inflation target range, while preserving financial stability. This, bearing in mind the negative differential between the Fed interest rate and that of the Bank of Israel.
  The Bank of Israel assesses that this cut in the interest rate is important, against the background of capital inflows into the market and the current account surplus in the balance of payments. These provide the backdrop to the strengthening of the shekel and the easing of pressure on prices so far, on the one hand, and the rapid reduction in the output gap, with its inherent upward pressure on prices, on the other.
  This decision to reduce the interest rate is consistent with the Bank’s monetary policy that is aimed at bringing inflation back to the midpoint of the target over the coming year, without causing financial shocks.
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, in particular to encourage employment and growth. In addition, the Bank will continue to support financial stability.