The Bank of Israel leaves the interest rate unchanged for May 2008 at 3.25 percent

28.4.2008
 
The Bank of Israel leaves the interest rate unchanged for May 2008 at 3.25 percent
 
The Bank of Israel announces that the interest rate will remain unchanged for May 2008, at 3.25 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) rose by 0.3 percent in March, exceeding expectations, whitch had ranged from no change to a reduction of 0.4 percent. The surprise was essentially the result of the rise of 0.4 percent in the housing index in March, in contrast to expectations of a decline of 1.5 percent. In the last twelve months the CPI has risen by 3.7 percent, and the CPI excluding the energy and food components by 1.8 percent.
Inflation and interest rate forecasts: Following the publication of the March CPI, Israeli forecasters revised their predictions upwards. They expect on average that inflation over the next twelve months will be 3 percent, and that the interest rate for May will remain unchanged. Inflation expectations for the next twelve months calculated from the capital market also rose to 3 percent. Interest rate expectations derived from the capital markets indicate a cumulative rise of 0.75 percentage points over the next twelve months.
Real economic activity: The most recently published data indicate that economic growth is continuing, but at less than the rate of about 5 percent of the last few years. The composite state-of-the-economy index for March rose by 0.5 percent, and the average monthly rise in the first quarter of 2008 was 0.4 percent, compared with 0.7 percent in the first quarter of 2007. The Companies Survey indicates a slowdown in the rate of growth of economic activity in the first quarter, with a similar outlook for the second quarter. Exports of the low-tech industries and imports of machinery, equipment and raw material remained steady in the first quarter, but high-tech exports continued to expand.
The labor market and wages: National Insurance Institute data show that the rapid increase in the number of employee posts persisted, and in the months from November 2007 to January 2008 the number rose by 4.7 percent compared with the equivalent period a year earlier. The data also show a rise of 3.7 percent in the nominal wage over the same period.
Budget policy: The execution of the budget since the beginning of 2008 suggests that the annual deficit will be consistent with the ceiling set by the government.
The foreign exchange market: In the period between the previous interest rate discussion on 23 March, and 27 April, the shekel weakened by 2.6 percent against the dollar and by 3.7 percent against the euro. This contrasted with the trend of most of the major currencies, which strengthened against the dollar by between 1 percent and 4 percent. Unlike in the previous month, when the volatility of the shekel/dollar exchange rate declined, this month it rose. Trading volume in the foreign exchange market stayed at the same high level as in the previous month, about $2.1 billion a day. Looking ahead, the shekel exchange rate is expected to be affected by continued capital inflows––by Israelis among others––which tend to strengthen the shekel. However, the expected change in the current account, the surplus in which is expected to decline to close to balance, or even to show a relatively small deficit, and the start of the implementation of the Bank’s planned purchases of foreign currency intended to increase the foreign exchange reserves by $10 billion in the next two years, will tend to weaken the shekel.
The capital and money markets: Against the background of rises in the leading stock exchange indices around the world, the Tel Aviv Stock Exchange also recorded rises. Between the previous interest rate discussion on 23 March, and 27 April, the Tel Aviv 100 share price index rose by 6.5 percent. Yields on 10-year unindexed government bonds went up to 5.89 percent, compared with 5.63 percent last month. The yield gap between these bonds and comparable US government bonds contracted this month to 2.02 percentage points, compared with 2.3 percentage points last month. Israel's sovereign risk premium, as measured by the five-year CDS premium, declined this month and reached 0.6 percent, down from 0.9 percent prior to the previous interest rate decision, a decline similar to those in the CDS spreads in the emerging markets.
The world economy: Against the background of the continuing crisis in the financial markets and the severe slowdown in the US, global growth is expected to slow this year. The risks of global inflation have risen recently due to increases in commodity prices, in particular oil and food prices. Thus, inflation in the previous twelve months in the US is 4 percent, and in Europe, 3.6 percent, due mainly to the continued rapid rise of energy and food prices. In light of the financial crisis, the markets expect the Fed to cut the interest rate on 30 April by 0.25 percentage points, to 2 percent. The ECB is expected to leave its interest rate unchanged at 4 percent almost to the end of the year. The Bank of England is expected to continue cutting the interest rate. Tensions in the financial markets calmed to some extent during the last month.
The main considerations behind the decision
The decision to leave the interest rate unchanged for May is consistent with a return of inflation to within the target range of 1–3 percent inflation in the next twelve months. The decision was based on an analysis of expected inflation developments, which at this time are affected by opposing forces:
  Inflation in the last twelve months is above the target, at 3.7 percent, similar to the rate in the advanced economies, particularly the US and Europe. This is due to the continued rises in energy and food prices, rises that are higher than expected. Hence, and following the publication of the surprising rise in the CPI in March, one-year-forward inflation expectations in Israel rose to 3 percent.
Ø The slowdown in global growth is expected to moderate the rises in world food and energy prices and to slow the expansion of economic activity in Israel, and thereby also moderate domestic inflation. First indications of a slowdown in Israel’s economic growth are already apparent in the Bank of Israel Companies Survey for the first quarter of 2008.
Ø In light of the slower growth in the advanced economies, interest rates abroad are expected to continue falling, albeit more slowly than previous assessments.
  The decision to keep the interest rate unchanged for May is consistent with support for growth and employment, subject to inflation returning to the price stability range.
The Bank of Israel will continue to monitor economic developments and their effect on inflation in Israel closely, and will stand ready to raise the interest rate as necessary to preserve price stability. Price stability is the central pillar supporting financial stability and the economy’s ability to achieve sustainable growth and to create jobs over the course of time.