The Bank of Israel keeps the interest rate for October 2008 unchanged at 4.25 percent

22.9.2008
 
The Bank of Israel keeps the interest rate for October 2008 unchanged at 4.25 percent
 
The Bank of Israel announces that the interest rate for October will remain unchanged at 4.25 percent.
Background conditions
Inflation data: The Consumer Price Index (CPI) rose by 0.8 percent in August, close to the top end of the forecasts, and above the seasonal path consistent with the inflation target. The August index excluding housing rose by 0.1 percent. In the last twelve months the CPI rose by 5 percent; the index excluding food, energy, and fruit and vegetables rose by 2.1 percent in the last twelve months, and by 1.1 percent in August.
Inflation and interest rate forecasts: Last month the downward trend in inflation expectations for the next twelve months calculated from the capital market continued, and they are currently around the midpoint of the target range, having peaked at 3.2 percent in July. Since mid-September expectations have fallen further, to below 2 percent. Forecasters expect, on average, that inflation over the next twelve months will be 2.9 percent, compared with their previous estimate of 3.2 percent. The expectations derived from the Makam market show that since the publication of the latest CPI, the capital market does not expect a change in the interest rate in the next twelve months. However, inflation over the preceding twelve months is likely to rise in the next months above its current level of 5 percent, declining in the first half of 2009 and returning to within the target range. Most forecasters expect no change in the interest rate for October. According to one of the Bank of Israel’s econometric models, a cut in the interest rate to 3.9 percent will be required in the fourth quarter of 2008, and with the exchange rate at its current level and following the drop in commodity and oil prices, inflation in the next twelve months will be 1.6 percent. The Bank’s other econometric model shows that by the end of 2008 and during 2009 the interest rate will have to rise, and that inflation in the next twelve months will be 3 percent. This model gives greater weight to the fact that the economy is close to full employment and to the high rate of inflation in the last few months.
Real economic activity: Real economic activity remains at a high level, although several indicators point to a slower rate of growth. The composite state-of-the-economy index for August rose by 0.1 percent, and the indices for the months from May to August have all been close to zero. The manufacturing production index, one of the components of the composite index, fell by 0.8 percent in July, after rising by 4.3 percent in June. Indirect tax revenues have dropped in the last few months. According to the Bank of Israel’s most recent macroeconomic forecasts, the rate of growth will slow in the second half of 2008 to an annual rate of 2.5 percent.
The labor market and wages: The rate of unemployment declined in the second quarter by 0.3 percentage points to 5.9 percent. The fact that the economy is almost at full employment is reflected in the fall of the rate of unemployment to its lowest level for 20 years, in the increase in employment of unskilled workers, and in an increase in the real wage. The real wage per employee post increased by 1.4 percent in the first half of the year. The nominal wage per employee post went up by 5.2 percent (seasonally adjusted, in annual terms) in the period from April to June, compared with April–June 2007.
Budget policy: From the beginning of the year to August the government’s domestic budget surplus was NIS 3.4 billion higher than the seasonal path consistent with deficit ceiling of 1.6 percent of GDP, despite the drop in tax revenues. Tax revenues from the beginning of the year to August, after deducting the effects of a change in tax rates and non-recurring receipts, were 0.9 percent lower in real terms than in the equivalent period in 2007, mainly due to a sharp fall in receipts of corporation tax and tax on the capital market. Indirect tax revenues, on the other hand, rose by a real 3.4 percent.
The foreign exchange market: In the period between 24 August (the date of the previous interest rate discussion) and 21 September, the shekel weakened by 0.5 percent against the dollar, and strengthened against the euro by 2.7 percent. This weakening of the shekel against the dollar was more moderate than that of other currencies around the world, with the dollar strengthening by up to 7 percent against most of the major currencies.
The capital and money markets: From 24 August (the date of the previous interest rate discussion) to 21 September, the leading share indices abroad dropped sharply, with a sharp rise in their volatility. In the emerging markets the falls ranged from 3 percent to 13 percent. The Tel Aviv 25 share price index also fell by a steep 11 percent. Yesterday, 21 September, there was a sharp reversal, with the Tel Aviv 25 index surging by more than 8 percent and other share indices around the world recording gains of between 5 percent and 10 percent. Yields on 10-year unindexed government bonds rose by 0.1 percentage points to 6.03 percent. Yields on US government 10-year bonds continued to fall, dropping this month by 0.1 percentage points to 3.77 percent, so that the yield gap between the Israeli bonds and US government bonds widened to 2.26 percentage points. Israel's sovereign risk premium, as measured by the five-year CDS spread, increased markedly from 0.88 percent prior to the previous interest rate decision (on 24 August) to 1.07 percent, after reaching––in the course of the previous week––its highest level since the outbreak of the crisis. The CDS spreads in emerging markets also widened sharply, with most of the rise occurring after the announcement of the bankruptcy of Lehman Brothers.
The world economy: There has recently been a considerable further deterioration in the global financial crisis. The collapse of Lehman Brothers and disturbing news about other institutions unsettled the markets again. Share prices fell sharply again, the various risk indices rose, spreads reached record levels, and US Treasury bills were traded with negative yields. This resulted in the Department of the Treasury and the Federal Reserve introducing several measures aimed at dealing with the problems of the financial system and the financial markets. A few days ago the US administration took a step that surpassed all the previous ones, when the Treasury announced that it would ask for congressional approval to buy problem assets from the financial institutions in the amount of about $ 700 billion. Economic activity: The global slowdown is spreading, and is now evident in almost all markets. The key question is how long the global slowdown in growth will last, and how severe will it be. That said, most forecasters are more optimistic about the US economy than they are about the other G7 countries, partly due to the determined steps taken by the US Treasury and the Federal Reserve to end the crisis. Nevertheless, it is generally expected that the slowdown will become more severe. Inflation: The fall in commodity prices, and mainly in oil prices which this month dropped to below $100 a barrel for the first time in six months, together with the worsening economic slowdown and the severe credit crisis––which together are expected to return inflation to its target in most economies—led to cuts in interest rates in several countries and to a higher probability of reductions in many others.
The main considerations behind the decision
The decision to leave the interest rate for October unchanged is aimed at returning inflation to the target range of 1–3 percent in the next twelve months, and emerges from the various considerations involving inflation, the higher uncertainty in the financial markets, and real developments in Israel’s economy.
  Inflation in the last twelve months stands at 5 percent, above the upper limit of the price stability target range. However, the decline in global commodity and energy prices in the last two months is likely to help to reduce inflation in Israel and abroad. Against this background, and the background of the latest increases in the interest rate by the Bank of Israel, inflation expectations for the next twelve months derived from the capital market and those of the private forecasters are now within the target range.
  The financial crisis in the US worsened recently, and around the world and in Israel uncertainty and the volatility of financial assets increased.
  Israel’s economy is close to full employment. Several indicators, however, suggest that the rate of growth in real activity is slowing––the decline in recent months in indirect tax revenues, the very moderate changes in the composite state-of-the-economy index, and the low level of demand for private consumption and investment. Labor market data, showing the increase in demand for workers and employment, indicate that real economic activity in Israel is still at a high level.
The Bank of Israel will continue to closely monitor Israeli and worldwide economic developments, and will take whatever steps are necessary to achieve price stability, which is an essential requirement for sustainable growth, and to support the stability of the financial system. Subject to this, the Bank will continue to support the attainment of a range of macroeconomic objectives, in particular employment and growth.