The Bank of Israel raises the interest rate for January 2008

24.12.2007
 
The Bank of Israel raises the interest rate for January 2008
by 25 basis points to 4.25 percent
 
The Bank of Israel announces that the interest rate for January 2008 will rise by 25 basis points, to 4.25 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 November by 0.4 percent, exceeding the forecasts that ranged between a reduction of 0.3 percent and a rise of 0.1 percent. In the last twelve months the CPI has risen by 2.8 percent.
Inflation forecasts: Israeli forecasters expect, on average, that the 2007 inflation rate will reach 3.2 percent, and that inflation over the next 12 months will be 2.7 percent. They also expect, on average, that the Bank of Israel’s interest rate will rise by 0.75 percentage points by the end of 2008. Expectations of inflation over the next 12 months, as derived from the capital markets, have risen from 1.2 percent in the two months prior to the previous interest rate decision (on 26 November 2007) to 1.9 percent following the publication of the November CPI. Derived expectations of the Bank of Israel interest rate are that it will rise a little in the next quarter. According to the econometric model of the Research Department, an increase in the interest rate will be needed to keep the inflation rate within the target range in the next 12 months. According to the Monetary Department’s model, inflation will remain within the target range without a change in the interest rate. In both cases the assumption is that the exchange rate remains at the present level.
Real economic activity: The composite state-of-the-economy index for November rose by 0.6 percent, a sign of the continued growth of economic activity. Furthermore, the indices for September and October were revised upwards. Private consumption increased steeply in the third quarter, exports rose at a faster pace, investment in fixed capital rose, and the rise in imports slowed. It is possible that the implications of the financial crisis will reduce the rate of economic activity in 2008.
The labor market and wages: The manpower survey for the third quarter of 2007 shows that unemployment fell from 7.5 percent in the second quarter to 7.3 percent in the third. The number of employees in the business sector and public sector increased in the third quarter by 5.9 percent and 2.6 percent respectively compared to the third quarter of 2006. Continuing the trend that started in the last quarter of 2006, real labor productivity rose by 1.4 percent in the third quarter, and labor costs per hour increased by 2.8 percent compared to the second quarter.
Budget policy: The government’s budget surplus since the beginning of the year reached NIS 7.7 billion, and it appears that the budget will end the year close to balance. At a time when global economic developments and their effect on Israel’s economy are unclear in light of the credit crisis, it is important to continue to adhere strictly to the budget framework that played a major role in sustaining economic growth over the last few years. This is necessary in order to increase the chances of sustaining the growth trend in 2008. Hence it is important that the proposed budget for 2008, which has been approved by the government and has passed its first reading in the Knesset, be passed in accordance with the budget guidelines.
The forex market: The period between the previous interest rate decision on November 26 and December 23 started with the weakening of the shekel against the dollar, and ended with its strengthening. Over the whole of the period the shekel weakened against the dollar by 1.4 percent, and was highly volatile. During that period the shekel strengthened against the euro by 1.8 percent. The strengthening of the dollar against the shekel was in line with its strengthening against most currencies. It appears that in the current account and capital imports in 2008 the basic pressures for the strengthening of the shekel against the dollar will ease somewhat.
The capital and money markets: Since the previous interest rate decision (on November 26) till December 23, the leading Tel Aviv Stock Exchange indices rose by approximately 4 percent, as did the leading stock exchanges world wide. At the same time the yield on 10-year unindexed Israel government bonds rose by 0.6 percentage points, mostly after the publication of the November CPI. The yields on 10-year US government bonds also rose, by 0.2 percentage points. Thus the gap between yields on unindexed Israel government bonds and comparable US government bonds widened from 1.7 percentage points prior to the previous interest rate decision to 2.1 percentage points currently. Israel's sovereign risk premium as measured by the five-year CDS spread rose to 0.32 percent from 0.27 percent prior to the previous interest rate decision, while risk premiums in financial markets around the world rose.
The world economy: Following a certain measure of calm in September and October, the effects of the credit crisis in the financial markets of the United States and Europe reappeared last month. Financing difficulties remained severe, and continued to constitute an obstacle to full market recovery. As part of the global effort to improve interbank liquidity, the major central banks continued to inject liquidity into the financial markets. Growth in the leading markets is expected to be slower than previously estimated, but global growth is expected to remain relatively strong, thanks mainly to the anticipated high rate of growth in the emerging markets. Inflation in the leading economies is higher than expected, against the background of the rise in world oil and food prices. Against this backdrop, the Fed is expected to continue reducing its interest rate, while the ECB and the Bank of Japan are expected to leave their interest rates unchanged.
The main considerations behind the decision
  The rise in the interest rate is necessary to try to meet the inflation target, in light of the rise in inflationary pressures reflected both in actual inflation and in inflation expectations. These pressures arise from several sources:
  a. continued rapid economic growth and the closing of the output gap;
  b. the rise in import prices, reflecting among other things the worldwide rise in food and energy prices.
  These pressures may cause inflation to exceed the upper limit of the target range in the next few months. The rise in the interest rate is intended to act to return inflation to within the target range.
  Continued rapid growth, and the efficient operation of Israel’s financial markets (despite the global credit crisis), enable the Bank of Israel to focus on attempting to achieve the inflation target. This, in spite of the expectation that other central banks will continue with their expansionary policies.
  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.
 
for your information:
The minutes of the discussions prior to the above interest rate decision will be published on 7 January 2008.
The decision regarding the interest rate for February will be published at 18:30 on 28 January 2008.