The Bank of Israel leaves the interest rate for February 2008 unchanged at 4.25 percent

28.1.2008
 
The Bank of Israel leaves the interest rate for February 2008 unchanged at 4.25 percent
 
The Bank of Israel announces that the interest rate for February 2008 will remain unchanged at 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 by 0.6 percent in December, the second consecutive month in which the index rose steeply, relative both to the seasonal path and to earlier estimates. In the whole of 2007 the index rose by 3.4 percent, above the upper limit of the target range. Excluding the energy and food components, prices of which rose steeply throughout the world in the second half of the year, the index rose by 1.6 percent in 2007.
Inflation and interest rate forecasts: Israeli forecasters expect, on average, that inflation will return to within the target range in the second half of 2008, and over the whole of 2008 it will be 2.5 percent. Their expectations regarding the Bank of Israel interest rate at the end of 2008 range from a 25-basis-point reduction from the current level, to a rise of 1.25 percentage points above the current level. Inflation expectations for the next twelve months derived from the capital market have continued to rise, and have reached 2.5 percent. At the same time, average interest-rate expectations in January derived from the capital market are for a rise of 0.5 percentage points by the end of 2008. The Bank of Israel assesses that inflation will return to within the target range around the middle of the year and at the end of the year will be close to its midpoint. Since the Bank’s different econometric models indicate differing scenarios, they received less than their usual weight in the discussions prior to this interest rate decision.
Real economic activity: National Accounts estimates for 2007 and other economic indicators show that GDP continued to grow rapidly, with no signs of a slowdown. The composite state-of-the-economy index rose by 1.2 percent in December, and the indices for the previous two months were revised upwards. Foreign trade data for 2007:Q4 show that goods exports expanded at a fast pace. The expected slowdown in global growth may, however, affect Israel’s economy, and dampen growth somewhat in 2008 compared with the rate in 2007.
The labor market and wages: Employment continued to increase. The number of employee posts increased in August–October 2007 by 4.1 percent compared with the number in the equivalent period in 2006. This reflects a large increase in the business sector, with a more modest rise in the public services. The nominal wage per employee post rose by 2.7 percent in August–October 2007 compared to that in August–October 2006. Following the reduction in income tax and wage agreements in the public sector, from January 2008 the net wage of a large proportion of wage-earners is expected to increase by up to 4 percent.
Budget policy: The government’s overall budget deficit, excluding credit, totaled NIS 100 million in 2007, close to balance, mainly due to a sharp rise in government revenues, which exceeded the original budget estimate by about NIS 15 billion. The government’s budget proposal for 2008 was passed by the Knesset in accordance with its original targets for the deficit and the growth in expenditure.
The forex market: In the period between the previous interest rate decision on December 23 and January 26, the shekel strengthened by 5.2 percent against the dollar, and by 2.8 percent against the euro. At the same time the dollar weakened against most currencies, and by more than average against the shekel. The dollar-shekel exchange rate became more volatile. The level of activity in the forex market rose.
The capital and money markets: Since the previous interest rate decision (on December 23) till January 27, the leading international indices recorded sharp falls of up to 16 percent. On the Tel Aviv Stock Exchange, the Tel Aviv 25 and Tel Aviv 100 share price indices fell by about 13 percent. Whereas last month yields on 10-year unindexed government bonds rose, in this period the yields declined from 6.19 percent to 5.92 percent. Concurrently, yields on US government bonds also fell, by between 0.5 percentage points and 1 percentage point. Hence, the yield gap between unindexed Israel government bonds and comparable US government bonds widened again this month and reached 2.4 percentage points (from 2 percentage points last month). Israel's sovereign risk premium as measured by the five-year CDS premium rose sharply to 0.55 percent from 0.32 percent prior to the previous interest rate decision. The CDS spread widened markedly also in the other emerging markets, and surpassed their levels at the start of the crisis.
The world economy: Data on the US economy published this month indicated that it is suffering a slowdown in its rate of growth, and increased the number of assessments that it was likely to enter a recession as early as the first quarter of 2008. This concern, together with concern over a significant slowdown in global growth, caused further turbulence in the financial markets and led to sharp price falls, which accelerated in the last few days. Against this background, the Federal Reserve cut the interest rate by 0.75 percentage points, earlier than the scheduled date. The market in the US expects the Fed to cut the interest rate again at its next meeting on 30 January. Market expectations regarding the ECB interest rate in the next few months range between a reduction in the rate and no change. .
The main considerations behind the decision
The decision to leave the interest rate unchanged is intended to bring inflation, measured over the previous twelve months, to within the target range by the middle of 2008––even if it is expected to be above the target in the first half of the year––and to bring it close to the midpoint of the range by the end of the year. It is also intended to continue to support financial stability, particularly at the present time––this, as part of the infrastructure essential for sustained economic growth. The decision takes into account both the inflationary forces acting at present in the economy, and the influence, current and expected, of forces operating in the opposite direction.
  The economy is subject to inflationary pressures, deriving both from persistent rapid growth and the closure of the output gap, and from the rise in import prices, particularly energy and food prices, in the second half of 2007.
  On the other hand:
  1) The expected slowdown in US economic growth and in world trade should serve to reduce inflationary pressures in Israel. It will do so via its effects on Israel’s exports and by reducing domestic demand, as well as by moderating the rise in import prices, including energy and food prices.
  2) The assessments in the financial market are that the Fed will reduce the interest rate again on 30 January––the second reduction this month.
  3) The weakening of the dollar against the shekel is expected to moderate upward pressure on prices in the next few months, although to a lesser extent than in the past, in light of the slackening of the link between the shekel/$ exchange rate and the rate of inflation in Israel.
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 11 February 2008.
The decision regarding the interest rate for March 2008 will be published at 18:30 on 25 February 2008.