The Bank of Israel lowers the interest rate for February 2007 by 25 basis points to 4.25 percent

The Bank of Israel lowers the interest rate for February 2007 by 25 basis points to 4.25 percent
The Bank of Israel announces that the interest rate for February 2007 will be lowered by 25 basis points to 4.25 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) remained unchanged in December, slightly above expectations. Over the year 2006, the CPI changed minimally by –0.1 percent, below the inflation target range of 1–3 percent. However domestic prices–– prices that are not influenced directly by changes in the exchange rate––rose by more than 2 percent in annual terms. Following the cumulative fall of 1.8 percent in the CPI from September to November 2006, inflation over the past 12 months is expected to be lower than the target for the first three quarters of 2007.
Inflation expectations for the next year derived from the capital market were close to 1 percent in January 2007, after falling in the last quarter of 2006 from about 2 percent, the level around which expectations fluctuated in the first three quarters of last year. Expectations derived from the yield curve imply a further reduction in the interest rate in the course of the next twelve months. Forecasters predict an inflation rate for the next 12 months of 1.9 percent, close to the midpoint of the target range. They also expect, on average, that the Bank of Israel interest rate will reach 4.5 percent at the end of 2007. The econometric models of the Bank of Israel point to a relatively high probability that inflation for 2007 (taken over the preceding 12 months) will come within the inflation target range in the fourth quarter of 2007, subject to a modest reduction in the interest rate, mainly in the first quarter of the year.
National accounts data show a return to the high rate of economic growth that characterized the economy in the first half of 2006. The Bank of Israel's Companies Survey also shows a continued rise in activities in most industries and an expectation of continued expansion in the first quarter of 2007. The composite state-of-the-economy index in December and the revision upward of preceding months also indicate a strengthening of real activity. According to trend data in October and November of last year, the unemployment rate stands at 8.3 percent. This rate confirms the large fall registered in unemployment in the third quarter of 2006, to 8.3 percent, down from 8.8 percent in the second quarter. The tourism industry registered a rise in hotel nights (seasonally adjusted) at a rate in line with the rising trend seen after the sharp decline following the fighting in the north.
Nonresidents’ flow of investments in Israel continued in December, following the trend set since the beginning of 2006. Furthermore, exports continued to rise faster than imports creating a significant current account surplus in the balance of payments, which reached about 5 percent of GDP in the year 2006.
In the international financial markets, there was a further significant drop in Israel's risk premium, as measured by the five-year CDS spread, and in the yield gap between fixed-rate, 10-year Shahar local-currency bonds and 10-year US government bonds. In January, the negative interest rate gap between the interest rates set by the Bank of Israel and the US Federal Reserve reached 75 basis points. The US capital markets expect no change in the Fed rate in the coming month. Furthermore, the interest rate in Europe is on a rising trend.
The general budget deficit in 2006 totaled about 0.9 percent of GDP, below the planned ceiling. This was despite the fighting in the north. The 2007 budget, as approved by the government, was passed by the Knesset soon after the end of 2006, without the delay seen in previous years. According to the budget, the deficit ceiling for the current year is set at 2.9 percent of GDP, although the actual deficit for 2007 is expected to be lower than this.
The main considerations behind the decision
Recent economic developments have had counterbalancing effects on the rate of inflation. The reduction in the Israeli risk premium and the increase in the current account surplus of the balance of payments tend to strengthen the currency and reduce the inflation rate. The low budget deficit in 2006 and the expectations for a moderate deficit in 2007, reduce the net pressure of government demand on resources and further contribute to lower inflation. By contrast, the rapid growth that has reduced the output gap, tends to increase inflation. This effect has not yet been expressed in developments in the consumer price index, although there are certainly signs of an effect on local prices, that is, prices that are not directly affected by movements in the exchange rate.
In taking these considerations into account, the Bank of Israel concluded that in light of the very low level of inflation, which (measured over the past twelve months) is expected to return to within the target range only in the fourth quarter of this year, a further 25 basis point cut in the interest rate would strengthen the probability that the inflation rate would be close to the center of the target range towards the end of the year. Monthly changes in the CPI, in annual terms, are expected to return to the seasonal path consistent with the mid-point of the inflation target range by the end of the first quarter of the year.
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.