The Bank of Israel cuts the interest rate for March 2008 by 0.5 percentage points to 3.75 percent

25.2.2008
 
The Bank of Israel cuts the interest rate for March 2008 by 0.5 percentage points to 3.75 percent
 
The Bank of Israel announces that the interest rate for March 2008 will be reduced by 0.5 percentage points, to 3.75 percent. This step is taken in the context of the policy of maintaining price stability, in accordance with the inflation target of 1–3 percent a year.
Background conditions
Inflation data: The Consumer Price Index (CPI) remained unchanged in January, in line with earlier estimates, but above the seasonal path consistent with the midpoint of the inflation range. In the last twelve months the index has risen by 3.5 percent, above the upper limit of the inflation target.
Inflation and interest rate forecasts: Israeli forecasters expect, on average, that inflation in the next twelve months will be 2.3 percent. Most forecasters do not expect the interest rate to change in the next few months, and they assess that at the end of 2008 it will be 4.25 percent. Inflation expectations for the next twelve months derived from the capital market declined for the first time in four months, and are currently at 2.4 percent. At the same time, average interest rate expectations in January derived from the capital market are for a rise of about 0.5 percentage points by the end of 2008.
Real economic activity: Most of the economic indicators published during the last month show that economic activity continued to expand. According to National Accounts data, in the fourth quarter of 2007 GDP rose at an annual rate of 6.4 percent. Imports of investment goods and exports rose in November–January by 12 percent. In contrast, the composite state-of-the-economy index rose by 0.3 percent in January, a relatively low rate. In addition, the anticipated slowdown in the growth of the global economy is expected to affect Israel’s economy, and growth in 2008 is expected to be lower than the rates in the last few years.
The labor market and wages: The nominal wage per employee post fell by 0.1 percent in November 2007; in the last twelve months the nominal wage rose by 2 percent.
Budget policy: In January the government’s total activity excluding credit resulted in a surplus of NIS 4.9 billion. This level of surplus is normal for January, and has not changed during the last three years.
The foreign exchange market: The strengthening of the shekel that started in mid-December continued, and in the period between the previous interest rate decision on January 28 and February 24 the shekel appreciated by 3.2 percent against the dollar, and by 2.4 percent against the euro. The volatility of the shekel/dollar exchange rate continued its trend increase during the last month, a trend evident in most currency markets. The level of activity in the forex market was lower than in the previous month, but remained high. Since the period 2005–06, in which the real effective exchange rate of the shekel (the real exchange rate against the currencies of Israel’s trading partners weighted by their share of trade) was at its most depreciated level, the shekel has appreciated by about 10 percent.
The capital and money markets: In contrast to last month, when share prices fell sharply, between the previous interest rate decision (on January 28) and February 24, the leading international indices recorded mixed trends, and the Tel Aviv 25 share price index rose by 4 percent. Following the drop in yields on 10-year unindexed government bonds last month, the yields declined this month too, from 5.92 percent to 5.77 percent. The yield gap between unindexed Israel government bonds and comparable US government bonds contracted this month and reached 1.9 percentage points (compared with 2.4 percentage points last month). Israel's sovereign risk premium as measured by the five-year CDS premium continued to rise, and reached 0.8 percent, up from 0.55 percent prior to the previous interest rate decision. The CDS spread widened markedly also in the other emerging markets, and surpassed the levels prevailing at the start of the crisis.
The world economy: In the last quarter of 2007 the growth of the world economy slowed, reflecting the effects of the crisis in the US housing market and its consequences in the financial markets. Recently inflationary pressures have risen, against the background of the increase in commodity prices, mainly oil and food prices. Forecasters and the markets are increasingly pessimistic about the global economy in 2008. Updated forecasts regarding growth in the US are for an intensification of the growth slowdown, with some forecasting a recession. Forecasts for other advanced economies, including the European Union and Japan, indicate a more severe slowdown than previously expected. Against this background, the markets expect a reduction in the world interest rate environment following interest cuts by the central banks in the leading economies. Analysts and the markets expect the Fed to reduce its rate by 0.5 percentage points on 18 March. Expectations of a rise in the ECB interest rate have turned into expectations of no change or even a reduction this year. The Bank of England is also expected to continue to reduce its interest rate during this year.
The main considerations behind the decision
The decision to cut the interest rate for March by 0.5 percentage points is consistent with a return of inflation to within the target range of 1–3 percent inflation before the end of the year.
  In the last few weeks the forces acting to moderate inflation––mainly the increased chances of a significant slowdown in the global economy––have grown stronger, in contrast to the situation a month ago when the forces acting in opposite directions were balanced. This was reflected among other things by the January CPI, which rose more modestly than in the previous two months, and in the expected reductions in the CPI in the next two months. Underlying this are assessments that inflation measured over the previous twelve months will return to within the target range during the second half of the year, and will be close to its midpoint towards the end of the year. The reduction of inflationary pressures this month derived from the following developments:
  1) The more severe slowdown in growth in the US, Europe and Japan, and hence also in world trade, that is now expected is likely to impact the Israeli economy, and to lower inflation in the coming months.
  2) The strengthening of the shekel against other currencies since mid-December 2007 in itself acts to lower the pressures for price increases in the next few months, even if to a lesser degree than in the past.
  3) In light of the expectation of a lower global interest rate environment, a reduction in the Bank of Israel interest rate is required due to the moderating effect on price rises in Israel of the interest rate differentials between Israel and abroad, via the strengthening of the shekel.
  Subject to the reduction in inflationary pressures, as described above, the 0.5 percentage point cut in the interest rate is likely to support continued economic growth, while being consistent with inflation returning to within the target range this year.
The Bank of Israel will continue to monitor domestic and world 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.