The Bank of Israel raises the interest rate for August 2008 by 25 basis points to 4 percent

28.7.2008
 
The Bank of Israel raises the interest rate for August 2008 by 25 basis points to 4 percent
 
The Bank of Israel announces that the interest rate for August will rise by 25 basis points to 4 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) increased by a relatively moderate 0.1 percent in June, less than the forecasts had predicted. This increase is in line with the seasonal path consistent with meeting the inflation target. The housing, food, and fruit and vegetable components of the CPI contributed to the surprisingly low index. Since the beginning of 2008 the CPI has risen by 2.3 percent. In the last twelve months it has risen by 4.8 percent, and the CPI excluding the energy, food, and fruit and vegetables components has risen by 1.9 percent.
Inflation and interest rate forecasts: Israeli forecasters expect, on average, that inflation over the next twelve months will be 3.2 percent, above the upper limit of the target range. According to the Bank of Israel forecasts, inflation measured over the previous twelve months is expected to fall below its current level of 4.8 percent, to rise again towards the end of the year, and to return to the target range towards mid-2009. Israeli forecasters expect, on average, that the Bank of Israel interest rate for August will remain unchanged, and that within a year the rate will rise by about 0.4 percentage points. Inflation expectations for the next twelve months calculated from the capital market rose until mid-July, and reached approximately 3.5 percent. However, following the publication of the June CPI, those expectations fell sharply to about 2.8 percent, and expectations of a rise in the Bank of Israel interest rate moderated too. The current expectations derived from the capital market are for a rise of about 0.5 percentage points within a year. The Bank of Israel’s econometric models indicate that a rise in the interest rate is needed to return inflation to the target range in the next twelve months.
Real economic activity: Some recent data support the assessment that economic growth has slowed. The Companies Survey also suggests that the slowdown in growth is expected to continue. The composite state-of-the-economy index fell by 0.3 percent in June, and the updated index for May showed a decline of 0.1 percent. These two consecutive drops are evidence of a slowdown in the rate of growth. On the other hand, foreign trade data for June and sales in the retail chain stores show continued increases. Imports and exports, in dollar terms, rose from the first quarter to the second by 17.6 percent and 9.6 percent respectively, at annual rates. Retail sales in the chain stores rose at a rate of 4.4 percent in June, after declining in April and May.
The labor market and wages: Central Bureau of Statistics data show that the downward trend in the unemployment rate has continued, with unemployment declining from 6.2 percent in March-April to 6.1 percent in May. The average nominal wage rose in the months February–April by 4.8 percent, relative to the same period a year before.
Budget policy: The overall surplus in government activity, excluding credit, in the first half of 2008 totaled NIS 2.7 billion relative to the seasonal path. This derived from non-tax revenues. The assessment is that in 2008 the budget will be spent in full, and that the deficit will be below the ceiling of 1.6 percent of GDP.
The foreign exchange market: In the period between 22 June (the date of the previous interest rate discussion) and 27 July, the shekel weakened against the dollar by 3.9 percent and against the euro by 5.1 percent. The weakening of the shekel contrasted with the trend in the main currency markets, and it started with the announcement by the Bank of Israel that it was increasing the rate of its foreign currency purchases from $25 million a day to $ 100 million a day. The June CPI published on 15 July was lower than expected, and also contributed to the weakening of the shekel. The volatility of the shekel/dollar exchange rate remained high.
The capital and money markets: From 22 June (the date of the previous interest rate discussion) to 27 July, the Tel Aviv 100 share price index fell by 7.6 percent, reversing the trend of the previous month, but in line with the reductions in most leading share indices abroad. Yields on 10-year unindexed government dropped by 0.1 percentage points to 5.9 percent. The yields on US government 10-year bonds also declined by 0.1 percentage points, so that the yield gap between the Israeli bonds and US government bonds remained unchanged at 1.9 percentage points. Israel's sovereign risk premium, as measured by the five-year CDS spread, continued to rise this month from 0.63 percent before the last interest rate decision to 0.87 percent, similar to the development in the emerging markets.
The world economy: The most recent economic data point to a slowdown in global growth. Growth is expected to slow in the second half of the year in the US, Europe, the UK, and Japan. Although growth in the emerging markets is still high, in those countries too a slowdown is expected. At the same time, global inflation is accelerating in light of high commodity and oil prices. Nonetheless, this month there were considerable reductions in commodity and oil prices. The crisis in the financial markets became even more severe in the last few weeks in light of concern over the financial situation of Fannie Mae and Freddie Mac in the US. Concern over inflation resulted in many central banks switching to a tighter monetary policy. However, the probability of a rise in the interest rates of the Fed, the ECB and the Bank of England in the next few months declined, against the background of the expected slowdown in growth and developments in financial markets.
The main considerations behind the decision
The factors relevant to the decision on the interest rate relate to inflation and growth, and in each of these areas a mixed picture emerges.
  Inflation
Ø On the one hand, in the last twelve months the CPI has risen by 4.8 percent, and forecasters’ inflation expectations for the next twelve months and those derived from the capital market are around 3 percent, the upper limit of the inflation target range.
Ø On the other hand, the index excluding energy, food, and fruit and vegetables rose by 1.9 percent, close to the midpoint of the target range. The surprisingly low CPI in June led to a marked fall in twelve-month inflation expectations as calculated from the capital market. There have been reductions recently in commodity and energy prices, which will serve to moderate inflationary pressures in Israel. The assessment is that the upward trend evident hitherto in commodity prices has halted, and may even have reversed.
  Growth
Ø On the one hand, Israel’s GDP is close to its potential; import and export data for June indicate continued expansion, despite the fact that the strengthening of the shekel against the dollar since the beginning of the year is a factor tending to moderate exports and thus economic activity; and data on sales in retail chain stores show continued increases.
Ø On the other hand, the Bank of Israel’s Companies Survey and the May and June composite state-of-the-economy indices point to a slowdown in the rate of growth.
Given the above factors, the Bank of Israel decided to raise the interest rate by 25 basis points to 4 percent, to support the return of inflation and inflation expectations to around the middle of the target. The return of inflation to the target range is essential as a basis for sustainable growth.
The Bank of Israel will continue to closely monitor developments in the Israeli economy and worldwide, and will act to achieve price stability. Subject to this, the Bank will continue to support the attainment of a range of macroeconomic objectives, in particular the encouragement of employment and growth. In addition, the Bank will continue to support the stability of the financial system.