The Bank of Israel interest rate remains unchanged for April 2007 at 4 percent

26.3.2007
 
The Bank of Israel interest rate remains unchanged for April 2007 at 4 percent
 
The Bank of Israel announces that the interest rate for April 2007 will remain unchanged at 4 percent. This desicion is consistent with the policy of maintaining price stability, as expressed by the inflation target of 1–3 percent a year.
Background conditions
The Consumer Price Index (CPI) fell by 0.3 percent in February, in line with forecasters’ expectations. Adjusting for seasonality, the CPI dropped in February by 0.4 percent. In the last twelve months the CPI has fallen by 0.8 percent, so that the rate of inflation over that period was significantly below the target.
Israeli forecasters’ predictions of inflation for the next twelve months are close to the midpoint of the target range, at about 2.3 percent, slightly higher than their forecast of 1.8 percent for the year 2007. Most private forecasters do not expect a change in the interest rate for April, and on average they assess that the interest rate in the next few months will be between 4 percent and 4.5 percent. Market expectations derived from the capital market indicate inflation of 1.4 percent over the next twelve months, while the makam curve implies the assessment that the interest rate will not change during the next year.
Data on economic activity, based on the updated National Accounts figures for the fourth quarter of 2006, continue to indicate rapid growth. GDP rose by 5.1 percent, private consumption by 4.8 percent, gross fixed capital formation by 6.4 percent, and exports (excluding diamonds) by 9.3 percent. The decline in the unemployment rate to 7.7 percent in the fourth quarter of 2006, from 8.8 percent in the second quarter, also points to increased activity. At this stage, however, there are no signs of inflationary pressure deriving from the labor market, this is due to the rapid rise in productivity that resulted in a reduction in unit labor costs. In the light of these figures, the Bank of Israel updated its forecasts for 2007: GDP is now expected to grow by 5.1 percent, and business sector product by 6.2 percent.
The shekel/dollar exchange rate remained essentially unchanged in the last month, and the shekel weakened by about 1 percent against the euro. The strength of the shekel in the foreign currency market in the last year can be explained by both the current account surplus, which in 2006 reached about 5 percent of GDP, and by the considerable inflow of nonresidents’ investments into Israel. In the last month nominal long-term interest rates remained almost unchanged. On the stock exchange share prices fluctuated widely, against the background of the volatility of the major world stock exchanges.
In the international financial markets, Israel’s sovereign risk premium, as measured by the five-year CDS spread, remained relatively low, at 18 basis points. The yield gap between fixed-rate 10-year Shahar local-currency bonds and 10-year US government bonds widened from about 60 basis points at the time of the last interest rate decision to about 80 basis points in the days prior to the current decision.
In the international financial markets it is expected that the US Fed rate will be cut by 25 basis points by the end of the year. The Bank of Israel interest rate is currently 1.25 percentage points lower than the Fed rate. Last month the European Central Bank increased the euro interest rate, and the markets expect it to raise the rate by another 25 basis points by the end of the year.
Data of the budget performance for January/February show tax revenues significantly in excess of expectation based on the seasonal path, and expenditure below the seasonal path.
The main considerations behind the decision
The decision not to change the interest rate is in line with the Bank of Israel’s policy of aiming to return inflation to within the target range gradually, while maintaining financial stability.
  It is expected that during the next year rapid economic growth, in conjunction with the continued narrowing of the output gap, will act to bring inflation back into the target range. The marked drop in unemployment in the last quarter of 2006 strengthens the assessment that the narrowing of the output gap is proceeding faster than was thought previously.
  The cuts in the interest rate by the Bank of Israel each month since November 2006, totaling 1.5 percentage points, increase the probability that inflation will return to the target range in 2007. The effects of the large cumulative reduction in the rate have not yet been felt in full.
  In the light of the cuts in the interest rate in the last few months, and the steadying of inflation expectations one year forward at around the midpoint of the target range, the Bank’s rate of interest in real terms has reached the low level of 2.6 percent, which has an expansionary effect on growth.
  The domestic financial markets continue to show relative stability, despite the rise in the volatility of the international markets.
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.