The Bank of Israel reduces the interest rate for November 2008 by 25 basis points to 3.5 percent

27.10.2008
 
The Bank of Israel reduces the interest rate for November 2008 by 25 basis points to 3.5 percent
 
The Bank of Israel announces that the interest rate for November 2008 will be reduced by 25 basis points, to 3.5 percent.
Background conditions
Inflation data: The Consumer Price Index (CPI) remained unchanged in September, below the average forecast of 0.4 percent. In the last twelve months the CPI rose by 5.5 percent, well above the upper limit of the inflation target range of 1–3 percent a year. The index excluding food, energy, and fruit and vegetables rose by 2.9 percent in the last twelve months, and remained unchanged in September.
Inflation and interest rate forecasts: The downward trend in inflation expectations for the next twelve months continued: in October expectations calculated from the capital market averaged 0.4 percent (this low level is apparently due to technical factors). Forecasters’ twelve-month-forward predictions continued to fall, and following the publication of the September CPI reached an average of 1.3 percent. Interest rate expectations derived from the capital market show that no change in the rate is expected in the next twelve months. The forecasters, on average, expect a reduction of 25 basis points in the interest rate for November.
Real economic activity: Data received this month indicate a slowdown in the rate of expansion of real activity. This can be seen in the latest indicators (based on partial data) of the Central Bureau of Statistics (CBS) for the third quarter, which show a further slowdown in the rate of growth. The composite state-of-the-economy index for September dropped by 0.3 percent, and the indices for June and August were revised downwards, also becoming negative. Preliminary data from the Companies Survey for the third quarter show a drop in the growth of demand, and expectations of a further decline in the growth of activity in the fourth quarter. The slower rate of expansion was reflected also in tax revenues: health tax revenues, which serve as an indicator of total wage expenses in the economy, and VAT on domestic production slowed in the third quarter, and direct tax revenues (excluding the effect of changes in tax rates) fell by 7.9 percent, nominal rate, compared with the level in the third quarter of 2007. According to the Bank of Israel’s most recent macroeconomic forecasts, the rate of growth in 2009 will be 2.7 percent.
The labor market and wages: There are signs that the downward trend in the rate of unemployment in the last few years has halted. Unemployment trend data for July (seasonally adjusted) give a rate of 6.1 percent, similar to the level in the previous two months. From March to July there was no change in the number of employee posts (seasonally adjusted). The nominal wage per Israeli employee post rose by 0.6 percent in June–July compared with its level in April–May.
Budget policy: From the beginning of the year to September, the government’s domestic budget surplus was NIS 4.3 billion higher than the seasonal path consistent with the deficit ceiling of 1.6 percent of GDP, despite the drop in tax revenues, but due in part to under-expenditure of about 2 percent. Tax revenues in that period were 1.2 percent lower in real terms than in the equivalent period in 2007 (after deducting the effects of a change in tax rates and non-recurring receipts).
The foreign exchange market: In the period between the monetary policy discussions of 21 September and 26 October, the shekel weakened by 9.8 percent against the dollar, and by 3.8 percent against the index of the effective exchange rate (weighted by the volume of trade), and strengthened by 3.2 percent against the euro. In this period the dollar continued to strengthen significantly against most of the major currencies, by between 3 percent and 29 percent, so that the weakening of the shekel against the dollar was moderate compared with the global trend.
The capital and money markets: Between the interest rate discussion of 21 September and 26 October, the leading share indices abroad dropped sharply: in the advanced economies the indices plunged by between 19 percent and 40 percent, and in the emerging markets by between 10 percent and 47 percent. In this period the Tel Aviv 25 and the Tel Aviv 100 share price indices declined more moderately than the average, by about 20 percent. Yields on 10-year unindexed government bonds were unchanged at 6 percent. Yields on US government 10-year bonds continued to fall, dropping this month by 0.1 percentage points to 3.69 percent, so that the yield gap between the Israeli bonds and US government bonds widened to 2.35 percentage points. Israel's sovereign risk premium, as measured by the five-year CDS spread, increased markedly from 1.07 percent prior to the previous interest rate decision (on 21 September) to 2.20 percent, its highest level in the last five years. The CDS spreads in emerging markets widened even more sharply.
The world economy: The situation in financial markets around the world deteriorated further. Governments and central banks took unprecedented steps and announced far-reaching rescue plans, consisting mainly of massive injections of liquidity to the money markets both by the central banks and by means of government programs to carry out swaps of problem and illiquid securities for liquid assets, or government purchases of problem securities; granting explicit or implied government guarantees for bank deposits and bank bonds to prevent bank runs; and programs for nationalizing bankrupt banks or refinancing weak ones. For these purposes countries allocated in total about $3.3 trillion. First indications are that the programs are leading to an improvement in the situation and to the beginning of stabilization in the money and credit markets, but at the same time, a high degree of uncertainty still prevails. Economic activity: Confidence in the global economy slumped in the last month following the deeper freeze in the financial markets and the greater uncertainty that increased the probability of a global recession. The global economy is entering a period of a significant growth slowdown in the advanced economies, or even a recession in some of them, and the slowdown in growth is evident in emerging markets too. Inflation: Inflationary pressures world wide have started to ease against the background of the sharp drops in commodity and oil prices. The slowdown in global growth and the increase in unemployment support the trend of falling inflation. Against this background the major central banks reduced their interest rates, and are expected to continue to lower their rates and to maintain their low interest policies.
The main considerations behind the decision
The decision to reduce the interest rate for November, following the out-of-schedule reduction of half a percentage point announced on 7 October, is consistent with the objective of returning inflation to the target range of 1–3 percent in the next twelve months, with the strengthening of the economy’s ability to cope with the implications of the global financial crisis, and with the provision of support for real activity.
  Following the sharp falls in world commodity and energy prices and the expected slowdown in demand, forecasters’ predictions and expectations derived from the capital market are that inflation over the previous twelve months will return to the target range around the middle of 2009.
  The high level of uncertainty in the financial markets continued to rise, leading to expectations of further reductions in interest rates by central banks around the world. Against the background of the continued rise in uncertainty, the current cut in the interest rate is intended to reduce the cost of credit and to help the economy deal with the possible implications of the global financial crisis.
  The global slowdown is expected to be reflected by a slowdown in Israel’s rate of economic growth. The reduction in the interest rate is aimed at supporting economic activity.
The Bank of Israel notes that in light of the weakening of the transmission between developments in the shekel exchange rate and inflation, it appears that the depreciation of the shekel against the dollar recently has at this stage had only a minimal effect on inflation in Israel.
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, to support the stability of the financial system, and to encourage employment and growth.