The Bank of Israel lowers the interest rate for March 2007 by 25 basis points to 4 percent

The Bank of Israel lowers the interest rate for March 2007 by 25 basis points to 4 percent
The Bank of Israel announces that the interest rate for March 2007 will be lowered by 25 basis points to 4 percent. This step is consistent with the policy of maintaining price stability, in accordance with the inflation target of 1–3 percent a year.
Background conditions
The Consumer Price Index (CPI) declined by 0.1 percent in January, in line with forecasters’ expectations. Adjusting for seasonality, the CPI rose in January by 0.3 percent. In the last twelve months the CPI has risen by 0.1 percent, so that the rate of inflation over that period undershot the target. The strengthening of the shekel against the dollar constituted a major factor in the reduction of inflation to below the target range.
Israeli forecasters’ predictions of inflation for the next year are close to the midpoint of the target range, at about 1.8 percent. On average they estimate that the CPI will drop by 0.3 percent in February, and rise by 0.1 percent in March. Most private forecasters expect the interest rate for March to be reduced by 25 basis points, but the average of their assessments of the Bank of Israel interest one year hence is that it will be higher than the current rate, at 4.4 percent. Market expectations derived from the makam curve imply the assessment that in one year the interest rate will be at a similar level to its current one.
Data on economic activity indicate rapid growth. National Accounts figures published this month show that GDP rebounded in the fourth quarter of 2006 by 8 percent (annual rate), after falling by 0.7 percent in the third quarter as a result of the war in the north. In the whole of 2006 GDP grew at the rate estimated previously, i.e., 5.1 percent. Business sector product expanded by 12.8 percent in 2006:Q4, and by 6.3 percent over the year as a whole. The most recent indices suggest that activity might be increasing at a higher rate, with additional indications in the last month that the rise in construction activity too is become more firmly based. The composite state-of-the-economy index rose by 0.9 percent in January, and the index for December was revised upwards from 0.6 percent to 0.7 percent. In addition, goods imports and exports continued to rise in January. There are indicators of greater difficulty in obtaining skilled workers, and the rate of unemployment among those with higher education is close to its low level of the mid-1990s. The wage per employee post in the business sector rose by about 4 percent in January-November 2006 compared with the equivalent period in 2005. Till now, however, no signs of inflationary pressure from the labor market are evident, due to the rapid rise in productivity that reduced unit labor costs. It should be noted that the rate of reduction of unit labor costs is slowing.
The shekel strengthened against the dollar in the last month from about NIS 4.25 to the dollar around the time of the last interest rate decision to about NIS 4.19 in the last few days. The shekel also strengthened slightly against the euro, from NIS 5.49 to the euro at the time of the last decision, to about NIS 5.47 in the last few days. In other words, the strengthening of the shekel mainly reflects the worldwide weakening of the dollar. The strength of the shekel in the foreign currency market during the last year is explained by the surplus in the current account, which in 2006 reached about 5 percent of GDP, and by the considerable inflow of nonresidents’ investments to the economy. In the last month both real and nominal rates of interest continued to decline, with the 10-year CPI-indexed rate of interest dipping by 0.2 percentage points to 3.2 percent, and the nominal yield on 10-year unindexed bonds declining by 0.2 percentage points to 5.3 percent. The expected real interest rate one year forward declined in the last month from 3.6 percent to 2.9 percent.
Israel’s sovereign risk premium, as measured by the five-year CDS spread, declined a little in the international financial markets, from a level of 20 basis points last month to 18 basis points this month. The yield gap between fixed-rate 10-year Shahar local-currency bonds and 10-year US government bonds narrowed from about 70 basis points at the time of the last interest rate decision to about 60 basis points in the days prior to the current decision.
In the international financial markets it is expected that the US Fed rate will remain at 5.25 percent until the second half of the year. After the reduction in the Bank of Israel rate for March, it will be 1.25 percentage points lower than the Fed rate. Last month the European Bank left the euro interest rate unchanged, but the markets expect it to raise the rate next month by 25 basis points, with a further rise by the end of the year.
Data of the budget performance for January show tax revenues in excess of expectation based on the seasonal path, and expenditure below the seasonal path. Tax revenues were 7.1 percent higher than in January 2006. The privatization of the Oil Refineries (Bazan) will contribute to the further reduction of the public-debt/GDP ratio in 2007.
The main considerations behind the decision
  The reduction of the interest rate by 25 basis points is intended to increase the probability of returning inflation to within the target range in the course of 2007. It is expected that inflation, calculated over the previous 12 months, will revert to within the target range in the fourth quarter of the year. It is also expected that rapid growth in the year ahead, together with the contraction of the output gap, will act to bring inflation back into the range.
  Interest rate reductions do not have an immediate effect on inflation. Since the reduction in the rate for November 2006, the monthly cuts in the Bank of Israel’s interest rate total 1.5 percentage points.
The interest rate decision is consistent with the Bank of Israel’s policy of attempting to steer inflation back into the target range gradually, while 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, in particular the encouragement of employment and growth. In addition, the Bank will continue to support the stability of the financial system.