The Bank of Israel increases the interest rate for September 2008 by 25 basis points to 4.25 percent

The Bank of Israel increases the interest rate for September 2008 by 25 basis points to 4.25 percent
The Bank of Israel announces that the interest rate for September will increase by 25 basis points to 4.25 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) increased by 1.1 percent in July, higher than the forecasts, which had predicted 0.7 percent, and higher than the seasonal path consistent with the inflation target. The main factors contributing to the high index were the surprisingly high increase in the housing component, and the increases in energy, food, and fruit and vegetable prices. The CPI excluding the energy, food, and fruit and vegetables components, and the CPI excluding housing rose by a relatively high 0.9 percent and 0.8 percent respectively in July. In the last twelve months the CPI has risen by 4.8 percent, and the CPI excluding energy, food, and fruit and vegetables has risen by 1.3 percent.
Inflation and interest rate forecasts: Since the publication of the July CPI, Israeli forecasters expect, on average, that inflation over the next twelve months will be 2.7 percent, compared with 3.2 percent before the publication of the index. Most of them expect that the Bank of Israel interest rate for September will increase by 0.25 percentage points, and that it will remain around the new level during the next twelve months. 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 remained at that level even after the announcement of the surprisingly high July CPI. Current interest rate expectations derived from the capital market are for an increase of 0.25–0.5 percentage points within a year. According to the Bank of Israel forecasts, inflation measured over the previous twelve months is expected to return to the target range within the next twelve months, but is expected to be above its current level for some months before the end of the year. According to one of the Bank of Israel’s econometric models, an increase in the interest rate is needed this month to return inflation to the target range in the next twelve months; the second model does not suggest the need for an increase this month.
Real economic activity: National Accounts data for the first half of 2008 show continued growth in activity, but at a more moderate rate than before. The GDP increased at an annual rate of 4.2 percent in the second quarter, compared with 5.6 percent in the first. Thus GDP increased in the first half of the year by 5.3 percent, annually, and business sector product by 6.3 percent. In the second quarter goods and services exports increased at an annual rate of 6.6 percent, but the domestic uses (private consumption, public consumption, and investments) particularly private consumption, declined. The index of manufacturing production, which is one of the components of the composite state-of-the-economy index, rose steeply in June, by 5.5 percent, but the overall composite index declined by 0.3 percent in July, due to the fall in the indices of goods and services exports. At the same time the indices for the previous three months were revised upwards.
The labor market and wages: The trend data show that the increase in the number of employee posts slowed. In March–May the number increased by 3.6 percent compared with March–May 2007. In the December–May period the increase was 4.1 percent. The average nominal wage per employee post in March–May increased by 4.6 percent compared with March–May 2007.
Budget policy: From the beginning of the year to July the government’s domestic budget surplus was NIS 4.2 billion. It is expected 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. However, the downward trend in tax revenues persists, and in the last few months they have been below the seasonal path consistent with the forecast budget revenues. The budget for 2009 passed by the government, based on a planned increase in expenditure of 1.7 percent, and a deficit of 1 percent of GDP reflects the continuation of a responsible fiscal policy.
The foreign exchange market: In the period between 27 July (the date of the previous interest rate discussion) and 24 August, the exchange rate of the shekel against the dollar stayed unchanged, and against the euro the shekel strengthened by 5.9 percent. This month the dollar strengthened against most major currencies by between 2 percent and 7 percent. In contrast to the trend in the last few months, this month the volatility of the shekel/dollar exchange rate declined.
The capital and money markets: From 27 July (the date of the previous interest rate discussion) to 24 August, the Tel Aviv 100 share price index remained almost unchanged, after falling sharply in the previous month. During that period, the leading share indices abroad showed mixed trends. Yields on 10-year unindexed government bonds dropped by 0.15 percentage points to 5.75 percent. Yields on US government 10-year bonds also declined, by 0.2 percentage points, so that the yield gap between the Israeli bonds and US government bonds widened a little to 1.95 percentage points. Israel's sovereign risk premium, as measured by the five-year CDS spread, barely changed, and stood at 0.88 percent, similar to the development in the emerging markets.
The world economy: A year after its outbreak, the end of the credit crisis in the advanced economies is not yet in sight. Losses and write-offs in the financial system around the world continue, and recently crossed the $500 billion mark. In a recently published IMF report, the Fund warns that despite adjustments in the markets and despite steps taken by decision-makers, the financial markets are still in a fragile state, and the indicators of systemic risk remain high. Since the crisis began, forecasts of global growth have fallen, and data relating to the second quarter indicate a marked slowdown in growth in the advanced economies, particularly in Europe. At the same time commodity and energy prices are still falling, although till now these reductions have not affected inflation, which is still rising in the US, Europe and Japan, and which remains high in the eurozone. The Fed, the ECB, the Bank of England and the Bank of Japan kept their interest rates unchanged this month (at 2 percent, 4.25 percent, 5 percent, and 0.5 percent respectively). In light of the developments in inflation, growth, and the credit crisis, the markets expect no change in the Fed and the Bank of Japan interest rates till the end of the year, and the start of cuts in the interest rates of the ECB and the Bank of England in the next few months.
The main considerations behind the decision
The increase in the interest rate for September by 25 basis points is aimed at returning inflation to the target range of 1–3 percent in the next twelve months..
  Inflation in the last twelve months stands at 4.8 percent, and since the beginning of 2008 has been above the upper limit of the price stability target range of 1–3 percent. Inflation expectations have been in the upper part of the target range, although since the increase in the interest rate for August they have fallen, despite the high CPI in July. However, based on inflation expectations derived from the yield curve, the decline in expectations is based on the assessment that the Bank of Israel will raise the interest rate for September. The Bank of Israel expects that inflation will return to the target range during the second quarter of 2009.
  Oil and commodity prices have dropped sharply, but this is still a relatively new development. At this time it is difficult to assess how long the fall in prices will continue, if at all, and to what extent it will affect prices in Israel, against the background of the possible depreciation of the shekel among other things.
  Data on real economic activity show signs of continued growth, albeit at a slower rate than in the last few years. Employment is close to the full employment level and GDP is around its potential level. Further, in March–May the nominal wage increased by a relatively rapid 4.6 percent compared with March–May 2007.
  In light of the high actual and expected inflation rates, the real interest rate on Bank of Israel lending is low.
The Bank of Israel will continue to closely monitor developments in the Israeli economy and worldwide, and will act to achieve price stability, which is an essential requirement for sustainable growth. 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.