The Bank of Israel raises the interest rate for July 2008 by 25 basis points to 3.75 percent

The Bank of Israel raises the interest rate for July 2008 by 25 basis points to 3.75 percent
The Bank of Israel announces that the interest rate for July will rise by 25 basis 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) rose by 0.7 percent in May, in line with the forecasts, but higher than the upper limit of the seasonal path consistent with meeting the inflation target. In the last twelve months the CPI has risen by 5.4 percent, and the CPI excluding the energy, food, and fruit and vegetables components, by 2.6 percent.
Inflation and interest rate forecasts: Israeli forecasters expect, on average, that inflation over the next twelve months will be 3.1 percent, above the upper limit of the target range. They also expect, on average, that the CPI will rise by 0.4 percent in each of June and July. The forecasters expect, on average, that the Bank of Israel interest rate for July will rise by 0.3 percentage points. Inflation expectations for the next twelve months calculated from the capital market currently stand at 3 percent, the upper limit of the target range. Interest rate expectations derived from the capital markets indicate a cumulative rise of one percentage point over the next twelve months. The Bank of Israel’s econometric models indicate that an increase in the interest rate is required in order to return inflation to the target range within the next twelve months.
Real economic activity: Recently published data indicate that economic growth is continuing, but at a slower rate than previously. Following the high rate of growth in the first quarter of 2008, the Bank’s forecast of growth in 2008 was adjusted upwards to 4.2 percent. This forecast takes into account a significantly slower rate of growth as the year progresses, compared with that in the first quarter. The forecast of growth in 2009 was revised downwards to 3.1 percent, on the basis of the assessment that the slowdown in growth would start later than originally expected. The composite state-of-the-economy index for May was unchanged, the result of a rise in the index of manufacturing production that was offset by the declines in the indices of foreign trade, goods imports and exports, services exports, and trade and services revenue.
The labor market and wages: The data in the Manpower Survey for 2008:Q1 are in line with those of the National Accounts, indicating continued growth in that quarter. At the same time, the unemployment rate continued to fall, and reached 6.3 percent, compared with 6.7 percent in the previous quarter. The nominal wage rose by 4.7 percent in 2008:Q1, year on year. The rise in the public sector wage was partly due to the payment of various one-time wage components following the new wage agreement.
Budget policy: Budget data since the beginning of the year suggest a deficit path that will result in a deficit of about one percent of GDP, below the ceiling of 1.6 percent of GDP. Tax revenues in January–May, after deducting the effects of a change in the law and non-recurring receipts, rose in real terms by 2.7 percent, year on year.
The foreign exchange market: In the period between 25 May (the date of the previous interest rate discussion) and 22 June, the shekel weakened against the dollar by 0.6 percent and strengthened against the euro by 0.5 percent, with an increase in the volatility of the shekel/dollar exchange rate. In the last month the average daily forex trading volume was $2.2 billion.
The capital and money markets: From 25 May (the date of the previous interest rate discussion) to 22 June, the Tel Aviv 100 share price index rose by 1.4 percent, in contrast to the reductions in most leading share indices abroad. Yields on 10-year unindexed government remained unchanged at 6 percent. As a result of an increase of between 0.3 percentage points and 0.6 percentage points in yields on US government bonds, the yield gap between the above Israeli bonds and comparable US government bonds declined from 2.1 percentage points prior to the previous interest rate decision to 1.9 percentage points. Similar to the development in the emerging markets, Israel's sovereign risk premium, as measured by the five-year CDS spread, went up this month from 0.52 percent before the last interest rate decision to 0.7 percent.
The world economy: During the last month, following the continued sharp rise in global energy prices, concerns over inflation increased. Meanwhile, it appears that the global economic slowdown may be less severe than had been expected hitherto. Higher than expected growth figures for the first quarter were published in Japan, Europe, and the emerging markets. Data on US growth were also revised upwards. Current data for the second quarter show a mixed picture, and the general assessment is that the probability of a US recession has declined. Forecasts of the Fed interest rate reversed recently, and currently the expectation is that the next change will be upward. The markets reflect expectations that the ECB will raise the interest rate by half a percentage point by the end of the year, and that the Bank of Japan will leave its rate unchanged. The financial markets, on average, are showing signs of greater calm. However, the possibility of disappointing news from the financial sector together with concern over the effect of a surge in global inflation constitute elements of uncertainty regarding developments in the financial markets.
The main considerations behind the decision
  This current increase in the interest rate is required in light of the inflation environment that continues to be above the price stability target. Inflation over the previous twelve months was 5.4 percent, compared with the target range of 1–3 percent a year. One-year-forward inflation expectations derived from the capital market and the average of Israeli forecasters’ twelve-month inflation predictions are around the upper limit of the target range.
  The increase in the interest rate has an important task to fulfil in returning inflation to the target, because although most of the inflation in Israel is caused by the rise in global prices, it seems that some of the price rises in the last few months have been due to the high level of domestic demand.
  There are several reasons for the decision to raise the interest rate by 25 basis points: the high level of uncertainty regarding the future developments of energy and food prices abroad; the expected moderating influence on prices of the slower rate of growth predicted for the remainder of 2008 and for 2009; and the curb on prices due to the strengthening of the shekel, despite the weakening of the pass-through between them.
This increase in the interest rate is required to return inflation to the price stability target range of 1–3 percent inflation a year, and thereby to provide the basis that is essential to ensure that growth is sustained.
The Bank of Israel will continue to monitor economic developments worldwide closely, and will raise the interest rate as necessary to achieve price stability. 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.