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

27.8.07
 
The Bank of Israel raises the interest rate for September 2007 by 25 basis points to 4 percent
 
The Bank of Israel announces that the interest rate for September 2007 will rise by 25 basis points to 4 percent. This is consistent with the policy of maintaining price stability, as expressed by the inflation target of 1–3 percent a year.
Background conditions
Inflation data: The Consumer Price Index (CPI) rose in July by 1.1 percent, above forecasts that had predicted, on average, a rise of 0.8 percent. In the last twelve months the CPI has risen by a modest 0.3 percent, but since the beginning of the year by 2.1 percent. According to the Bank of Israel's econometric models, in the past 12 months local prices––the price component that is not directly affected by changes in the shekel exchange rate––have risen at a rate in excess of the upper boundary of the target inflation range.
Forecasts: Local forecasters expect, on average, that the inflation rate for 2007 will reach around 3 percent (the upper boundary of the target inflation range), and that inflation over the next 12 months will reach the midpoint of the range, 2 percent. At the same time, they expect, on average, that the Bank of Israel will raise the interest rate, and that in a year's time it will stand at 4.5 percent. The expectation of inflation over the next 12 months, as derived from the capital markets, stands at around 2 percent. The market also expects that the interest rate will rise over the next 12 months. The Bank of Israel's econometric models also imply that the interest rate needs to be raised if inflation is to be within the target range in the next 12 months and in 2008.
Real economic activity: Recently published indicators point to the continued rapid growth of the economy. The composite state-of-the-economy index rose in July by 1.1 percent, including a revision upward of earlier indices. National Accounts data published last week show that the economy grew at an annual rate of more than 6 percent, in annual terms, in the first half of 2007, and that both imports and exports of goods grew rapidly.
Labor market and wages: The Labor Force Survey for the second quarter of 2007 shows a rise in employment, with a significant increase in the rate of participation in the labor force, and a slight drop in the unemployment rate. Demand for workers in the business sector, according to the Employers Survey, shows a high level of demand. In the period March to May, there was a rise in average wage per employee post in all principal industries of the economy of 3.1 percent, compared to the corresponding period of last year. These developments took place against a background of a further slowdown in the increase in labor productivity, which is consistent with the closing of the output gap.
Budgetary policy: The cumulative government budget surplus since the beginning of the year stands at NIS 6.8 billion, and the budget deficit for 2007 is expected to be less than 1.5% of GDP. The proposed 2008 budget, which was approved by the government in August, and is consistent with the multi-year budgetary targets, together with a public sector wage agreement reached in July, contribute to the credibility of budgetary policy.
Forex market: Since the previous interest rate decision (on July 22) up till August 24, the shekel strengthened by 1.5 percent against the dollar and by 3.2 percent against the euro, while most other currencies weakened significantly against the dollar. The strengthening of the shekel since the beginning of the month is consistent with the underlying forces supporting the value of the shekel, notably the surplus in the current account of the balance of payments, and foreign investment in the economy.
Capital market: Events in the local capital market were affected by the credit crisis which occurred in the subprime mortgage market in the US and which expanded to other markets; since the previous interest rate decision (on July 22) up till August 23, the leading indices on the Tel Aviv Stock Exchange fell by around 8 percent. At the same time, yields on local unindexed government bonds for all terms to maturity rose by about 0.6 percentage points on average. Yields on corporate bonds also rose. As a result of the sharp fall in bond yields in the US, the gap between yields on 10-year unindexed bonds in Israel and in the US reached 1.45 percentage points. Israel's sovereign risk premium, as measured by the five-year CDS spread, rose to 0.33 percent, after remaining stable for some time at 0.17 percent. Despite the rise in volatility in the financial markets in Israel, there were no problems of liquidity in the markets, which continued to function well.
Global background conditions: Developments in the capital markets around the world were influenced by the credit crisis which occurred in the subprime mortgage market in the US and which spread to other markets. As a result of the crisis, investors reviewed the risk inherent in their portfolios, which led to their closing positions. As a result, there was a rapid drop in the price of those assets considered relatively risky and share prices fell. Since the previous interest rate decision (on July 22) up till August 23, indices of stock exchanges in the developed countries dropped by 6-12 percent, and in the developing markets by 9-15 percent. In the same period, the yield to maturity of bonds in developing countries rose while the yield to maturity of government bonds in developed countries such as the US, Germany and Japan, and with low risk, fell. The underlying conditions that the crisis created together with losses in the capital market are expected to impact on economic activity in the US and to a lesser extent in other countries too. However, the effect of the crisis on global growth is expected to be relatively slight due to the diffusion of sources of growth in the world. The crisis in the credit markets makes it considerably more likely that the US Federal Reserve will pursue an expansionary monetary policy, in contrast to expectations in recent months. In Europe, the tendency is still towards a tightening of monetary policy.
The main considerations behind the decision
  The decision to raise the interest rate is intended to increase the probability of meeting the inflation target, in light of the acceleration in the actual inflation rate in recent months, and in expectations of inflation in the future. This rise in expected inflation is fed by, inter alia, the rapid growth in the Israeli economy, and with it, the further contraction in the output gap reflected, among other things, by the continued rise in local prices.
  The decision to raise the interest rate by a relatively modest 0.25 percentage points was influenced by factors likely to moderate the forces of inflation in the future, which stem from the continuation of underlying forces that support the value of the shekel––the continued surplus in the current account and the inflow of capital––and from the expectations of a reduction in the interest rate in the US, which will contribute to the contraction of the interest-rate gap between the shekel and the dollar.
  The Bank of Israel notes that despite the rise in uncertainty in the financial markets, the markets in Israel are functioning well and have suffered no problems of liquidity. This is in contrast to the case in several developed countries.
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.