The Bank of Israel reduces the interest rate for December 2008 by 50 basis points to 2.5 percent

The Bank of Israel reduces the interest rate for December 2008 by 50 basis points to 2.5 percent
The Bank of Israel announces that the interest rate for December 2008 will be reduced by 50 basis points, to 2.5 percent.
Background conditions
Inflation data: The Consumer Price Index (CPI) rose by 0.1 percent in October, slightly below the average forecast of 0.2 percent. In the last twelve months the CPI has risen by 5.5 percent. The index excluding food, energy and fruit and vegetables rose by 3.5 percent in the last twelve months, and by 0.2 percent in October.
Inflation and interest rate forecasts: The downward trend in inflation expectations for the next twelve months that started in the second half of September continued in November: expectations calculated from the capital market averaged 0.2 percent (this low level may be partly due to technical factors), and forecasters’ predictions averaged 1.1 percent. Interest rate expectations, both those derived from the capital market and those of forecasters, are for a reduction of about 25 basis points on average in the interest rate for December.
Real economic activity: The picture that emerges from the monthly data, particularly those relating to September and October, is of a significant slowdown in economic growth. According to the National Accounts for the third quarter, GDP increased by 2.3 percent, and nonresidential investment dropped by 16.5 percent, both at annual rates. The composite state-of-the-economy index declined by 0.4 percent in October, and the indices for the previous three months were revised downwards. The index of manufacturing production, which is one of the components of the composite index, fell by 5.7 percent, and the index of manufactured exports declined by 5.2 percent. The drop in tax revenues is an indication of a significant slowdown in the growth of domestic economic activity and in imports, mainly of durables. The Bank of Israel cut its estimate of growth in 2008 and its forecast for 2009 to 4.3 percent and 1.5 percent respectively.
The labor market and wages: National Insurance Institute data up to August point to a standstill in employment in the third quarter (in contrast to the improvement recorded in previous quarters), and drops of 2 percent in the nominal wage and 5 percent in the real wage from their levels in the previous quarter. According to the Ministry of Industry, Trade and Labor Employers Survey, the number of vacancies has fallen, as have expectations of the rise in the payroll, but so far there is no sign of a change in the rate of employment terminations.
Budget policy: The rate of government expenditure fell sharply in the months from August to October, creating a cumulative shortfall of NIS 3.5 billion from the rate of expenditure consistent with the seasonal budget path. Government tax revenues were NIS 3.5 billion below the forecast seasonal path. Non-tax revenues exceeded the forecast by a similar amount, so that total government revenues are consistent with the seasonal path of the budget, and tax revenues till the end of the year are expected to be in line with the forecast. Based on developments till now, and assuming full expenditure of the budget, the domestic deficit excluding credit operations is expected to be below the target of 1.6 percent of GDP.
The foreign exchange market: In the period between the monetary policy discussions of 26 October and 23 November, the shekel weakened by 3.7 percent against the dollar, by 3.8 percent against the euro, and by 2.6 percent against the index of the effective exchange rate (weighted by the volume of trade). In this period the dollar continued to strengthen against most of the major currencies by up to 6 percent, so that the development of the exchange rate of the shekel against the dollar was in line with that of most of the main currencies.
The capital and money markets: Between the interest rate discussion of 26 October and 23 November, the Tel Aviv 25 and the Tel Aviv 100 share price indices declined 23 percent and 24 percent respectively. The leading share indices abroad also dropped. In this period yields on 10-year unindexed government bonds rose by 0.41 percentage points to 6.40 percent. Yields on US government 10-year bonds continued to decline, and this month fell by 0.49 percentage points, to 3.2 percent, so that the yield gap between the Israeli bonds and US government bonds widened to 3.2 percentage points. Prices of corporate bonds continued to fall in this period. The Tel-Bond 20 index fell by 9 percent, and the Tel-Bond 40 index by 18 percent. Israel's sovereign risk premium, as measured by the five-year CDS spread, increased markedly in the week following the previous interest rate decision on 26 October, from 2.20 percent to 2.51 percent, but then dropped back again to reach 2 percent on 21 November. The CDS spreads in emerging markets also widened to unprecedented levels.
The world economy: The crisis in the global financial system continued. The financial markets were still under heavy pressure, and uncertainty remained at a high level. The tightening of credit terms, in particular for households, persisted, despite significant cuts in the interest rates by central banks. Economic activity: In the last few months the global economy underwent a significant slowdown, verging on a recession. This resulted in downward revisions of the various growth forecasts, including those of the IMF, the OECD, the World Bank, and several investment houses. The IMF lowered its global growth forecast again this month, and this now stands at 2.2 percent for 2009. Inflation: The IMF expects that world inflation will remain high in 2008 and that it will moderate in 2009. Against that background many central banks made further cuts in their interest rates this month, and they are expected to maintain a low-interest policy.
The main considerations behind the decision
The decision to reduce the interest rate for December by half a percentage point is consistent with the objective of returning inflation to the target range of 1–3 percent in the next twelve months, it helps to strengthen the economy’s ability to cope with the implications of the global financial crisis, and supports real activity.
  Inflation expectations are for a reduction to around the lower limit of the target inflation range (1 percent) in the first half of 2009. Forecasters’ predictions and expectations derived from the capital market continued to fall, and since the beginning of the month have averaged 1.1 percent and 0.2 percent respectively.
  Against the background of the decline in global economic activity and the increased cost of credit to the Israeli business sector, the data on real activity in Israel indicate a more severe slowdown in the expansion of economic activity.
  Uncertainty in the global financial markets and in Israel’s financial markets is high.
  In light of the global financial crisis and the expected continued deterioration in global economic activity, as well as the worldwide reductions in inflation expectations, the capital markets expect central banks around the world to continue to cut their interest rates
The current reduction in the interest rate is intended to help cut the cost of credit and to strengthen the economy’s ability to handle the expected slowdown in economic activity and the implications of the global financial crisis. Furthermore, it appears that in the current circumstances, the depreciation of the shekel against the dollar does not at this stage threaten the achievement of the inflation target or financial stability.
The Bank of Israel will continue to monitor Israeli and worldwide economic developments closely, and will take whatever steps are necessary to support the stability of the financial system and to encourage employment and growth, as long as inflation continues to decline towards and achieve the price stability target.