The Bank of Israel interest rate for May 2007 cut by 25 basis points to 3.75 percent

The Bank of Israel interest rate for May 2007 cut by 25 basis points to 3.75 percent
The Bank of Israel announces that the interest rate for May 2007 will be cut by 25 basis points, to 3.75 percent. This step 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) rose by 0.2 percent in March, in line with forecasters’ expectations. Seasonally adjusted, the CPI also rose by 0.2 percent. In the last twelve months the CPI has fallen by 0.9 percent, so that the rate of inflation over that period is still significantly below the target.
Israeli forecasters’ predictions of inflation for 2007 and for the next twelve months are both below the midpoint of the target range, at 1.2 percent and 1.4 percent respectively. Their forecasts for 2008, however, at 1.9 percent, are close to the midpoint. Most private forecasters expect cuts of 25 basis points each in the interest rates for May and June, and on average they assess that the interest rate at the end of 2007 and twelve months hence, in April 2008, will be 4 percent. The expectation of inflation over the next 12 months, derived from the capital markets, is 0.5 percent, while the makam curve implies that the interest rate will decline slightly during the next year.
On the real side, data received since the last interest rate decision on 26 March 2007 give additional support to the assessment that rapid growth is continuing. Thus, the composite State-of-the-Economy index for March rose by 0.6 percent, while the revised indices for January and February were readjusted upward by a total 0.5 of a percentage point. Also, the number of employee posts increased over the last twelve months by 4.4 percent (calculated from the average for November 2006 to January 2007 compared with the same period a year earlier). Employment service data indicate a downward trend in the number of job hunters and an increase in the demand for workers. The nominal wage per employee post increased by about 3.1 percent in the last twelve months. The number of tourist hotel bed nights rose in February, indicating continued recovery in the tourist industry.
Tax revenues in the first quarter of 2007 exceeded the seasonal path of the budget, and expenditure was below its seasonal path.
The shekel exchange rate against the dollar declined since the previous interest rate decision at the end of March until mid-April by about 3.7 percent. Most of this appreciation of the shekel was due to the dollar’s weakening in the international markets, and also to Israel’s large current account surplus and the inflow of investments from abroad. In April nominal yields to maturity fell, and reached their lowest ever level, about 5 percent for the medium and long terms. In contrast, real medium- and long-term yields remained unchanged at about 3 percent. Share prices rose from the middle of March; the general share price index increased by 7 percent, and the Maof (Tel Aviv 25) index by 10 percent.
In the international financial markets, Israel’s sovereign risk premium, as measured by the five-year CDS spread, remained low, at 18 basis points. The yield gap between fixed-rate 10-year Shahar local-currency bonds and 10-year US government bonds contracted to its lowest ever level, 40 basis points.
In the international financial markets it is expected that the US Fed funds rate will be cut by 25 basis points by the end of the year. The Bank of Israel interest rate for May is 1.5 percentage points lower than the Fed funds rate. The markets expect the European Central Bank to raise the euro interest rate by 25 basis points by the end of the second quarter of 2007, and that there will be a further rise by the end of the year.
The main considerations behind the decision
  The main consideration in the previous interest rate decision, on 26 March 2007, was the rapid economic growth rate, with the implied narrowing of the output gap; the decision also reflected the Bank of Israel's commitment to maintaining financial stability. Rapid growth has persisted, and continues to help return inflation to within the target range. According to Bank of Israel assessments, domestic prices––that are not directly affected by changes in the exchange rate––are rising by more than 2 percent per annum. At the same time, since the last interest rate decision, estimates of future inflation––derived from the capital markets forecasters' predictions, and the Bank of Israel econometric models––have declined. This decline reflects mainly the strengthening of the shekel against the dollar (primarily due to the weakening of the dollar worldwide), which contributes to reductions in domestic prices.
  The decision to reduce the interest rate for May by 25 basis points was taken in the context of the Bank of Israel’s policy of continually attempting to return inflation gradually to within the target range by the end of the year, while maintaining financial stability. This policy provides the backdrop to the cuts in the interest rate since November 2006 totaling 1.75 percentage points.
  This current decision is part of the gradual process that will continue as long as necessary to increase the probability that inflation will return to the target range close to the end of 2007.
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.
Please note:
The minutes of the discussions prior to the above interest rate decision will be published on 7 May 2007.
The decision regarding the interest rate for June will be published at 18:30 on 28 May 2007.