The Bank of Israel lowers the interest rate for January 2007 by 50 basis points to 4.5 percent

The Bank of Israel lowers the interest rate for January 2007 by 50 basis points to 4.5 percent
The Bank of Israel announces that the interest rate for January 2007 will be lowered by 50 basis points to 4.5 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 November by 0.2 percent, in line with general expectations. This fall in the CPI stems mainly from the continued strengthening of the shekel against the dollar and the fall in prices of housing, transportation and communications. Since the beginning of the year the CPI has declined by 0.1 percent and has fallen in the past 12 months by 0.3 percent, below the lower limit of the target inflation range. Against the background that changes in the exchange rate have a rapid and strong effect on inflation, the strengthening of the shekel against the dollar has been a major factor in the reduction of inflation, both in recent months, and over the past 12 months. The strengthening of the shekel reflects the weakening of the dollar worldwide as well as several positive developments in the economy, principally the increase in the current account surplus in the balance of payments and the inflow of foreign investment into the economy. Following the cumulative fall in the CPI in the past three months––by about 2 percentage points––inflation (over the past measured 12 months) is expected to be lower than the target throughout the first half of 2007.
Inflation expectations for the next twelve months derived from the capital market were in the vicinity of the midpoint of the target inflation range from the beginning of the year until September 2006. Since October, however, they were below the midpoint of the range and in December they reached about 1.3 percent. Expectations derived from the yield curve indicate a reduction in the interest rate of 0.3 of a percentage point in the course of the next twelve months. In addition, the forecasters predict inflation for the next 12 months below the midpoint of the range, at 1.5 percent, and expect, on average, that the Bank of Israel interest rate will reach 4.75 percent at the end of 2007. The econometric models of the Bank of Israel suggest that conditioned on a reduction in the interest rate, the inflation rate for 2007 is likely to be within the inflation target range by the fourth quarter of 2007.
Annual economic growth rate for 2006 is expected to reach 4.8 percent, despite the hostilities in the north during the summer. The current rapid rate of growth is similar to that in the first half of the year. Though the composite state-of-the-economy index in November rose by 0.1 percent, it is still too early to deduce from this any change in the rate of development of economic activity. Unemployment fell in the third quarter of 2006, while unit labor costs rose only slightly in the same period as labor productivity continued to rise rapidly. The current account surplus in the balance of payments increased in the third quarter by $ 2.4 billion, totaling $ 6 billion since the beginning of the year, which is some 4.7 percent of GDP. Foreign trade data for November show continued export growth, and a slowing of the rate of growth in goods imports.
Nonresidents’ flow of investments in Israel continued unabated in November, following the trend set earlier in the year.
In the international financial markets, Israel's risk premium, as measured by the five-year CDS spread, fell further, as it did for other countries. The yield gap between fixed-rate, 10-year Shahar local-currency bonds and 10-year US government bonds also continued to contract. At the same time, the Fitch rating agency raised Israel's outlook from Stable to Positive.
Data on the performance of the government budget show a continued recovery in tax revenues, while expenditure increades have slowed, such that the annual budget deficit is expected to reach about 1 percent of GDP. Assuming the Knesset will approve the 2007 budget in line with the framework approved by the government, the budget deficit for the coming year is expected to be consistent with the ceiling set in the budget, of 2.9 percent.
The main considerations behind the decision
The decision to cut the interest rate by 50 basis points is, intended to raise the probabilities that inflation will return to within the target range during 2007. As the CPI has fallen cumulatively in recent months, the Bank of Israel does not expect inflation as measured by the increase in the CPI over the past 12 months––to return to within the target range until the second half of 2007.
This decision is consistent with the Bank of Israel's policy to gradually bringing the inflation rate back to the target range, while preserving 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, in particular to encourage employment and growth. In addition, the Bank will continue to support financial stability.