The Bank of Israel increases the interest rate for September 2009 by a quarter of a percentage point

24.8.2009
 
The Bank of Israel increases the interest rate for September 2009 by a quarter of a percentage point
 
The Bank of Israel announces that the interest rate for September 2009 will increase by 0.25 percentage points to 0.75 percent.
(Please note: the interest rate for October 2009 will be published at 17:30 p.m. on Thursday 24 September 2009.)
Background conditions
Inflation data: The Consumer Price Index (CPI) rose by 1.1 percent in July, exceeding the forecasters' expectations of an increase of 0.8 percent to 0.9 percent. Excluding the effects of the changes in tax rates and government-supervised prices, however, the July increase in the CPI was about 0.5 percent. Continuing the trend that started in April, prices rose in most of the components of the index. Since the beginning of the year the CPI has increased by 3.2 percent, and measured over the previous twelve months, by 3.5 percent.
Inflation and interest rate forecasts: At the beginning of August forecasters' inflation expectations twelve months forward and expectations derived from the capital market increased to around the upper limit of the target inflation range, but following the publication of the July CPI they declined sharply, and reached close to the midpoint of the range. Thus, last week the forecasters' twelve-month forward inflation expectations averaged 2.3 percent, and expectations calculated from the capital market were 2.2 percent. The averages of forecasters' inflation expectations are for an increase of 0.6 percent in August and for a decline of 0.2 percent in September. According to these forecasts, inflation over the previous twelve months is expected to remain around the upper limit of the target range in the next few months.
Forecasters' and capital market expectations of the Bank of Israel interest rate for September ranged from no change in the rate to an increase of a quarter of a percentage point; the average of the forecasters' expectations of the interest rate a year hence is 2.1 percent, and expectations derived from the capital market average 2.5 percent.
Real economic activity: The latest data available indicate that the decline in activity has halted, and that there has been a shift towards an upward trend, albeit a moderate one. National Accounts data for the second quarter show some increase in GDP, with growth in exports and private and public consumption. GDP increased in the second quarter at an annual rate of 1 percent, after declining in the first quarter at a rate of 3.7 percent; goods and services exports increased at a rate of 5.8 percent, and private consumption at a rate of 4.4 percent.
The July composite index of the state of the economy increased by 1.2 percent, and the indices for the previous three months were all revised upwards. The increase in the index was the result of increases in all its components, and in particular in the index of manufacturing production and of trade and services revenue.
The labor market and wages: The Ministry of Industry, Trade and Labor employers survey shows that the decline in the demand for workers continued in the second quarter, but at more moderate rate than in the previous quarters. Employment Service data indicate a downward trend since April in the number of new jobseekers, and a reduction in the number of dismissals. However, the rate of unemployment, according to the Central Bureau of Statistics trend data, continued to increase in May, and reached 8.4 percent. The real wage in the three months March–May was 3.4 percent lower than that in March–May 2008, and the nominal wage was 0.3 percent lower.
Budget data: In January–July 2009 the budget deficit (excluding credit) totaled NIS 17.3 billion, in contrast to budget surpluses in those months in previous years. The large deficit in domestic activity reflects the steep drop in tax revenues that started in the middle of 2008. In July indirect tax revenues increased for the first time this year, and the government had an overall budget surplus of NIS 0.4 billion, excluding credit.
The foreign exchange market: In the period between the monetary policy discussions of 26 July and 21 August, the shekel strengthened by 1.3 percent against the dollar, and by 0.7 percent against the euro. In terms of the index of the effective exchange rate vis-?-vis the currencies of Israel's trading partners (weighted by the volume of trade), the shekel strengthened by 1 percent. The strengthening of the shekel was supported by the positive indicators relating to Israel's economy published during the month, and by the July CPI, which exceeded expectations. The Bank of Israel's announcement about the change in its intervention policy in the foreign exchange market and the ending of its regular daily purchases of foreign currency also contributed to the strengthening of the shekel.
The capital and money markets: Between 26 July and 21 August the Tel Aviv 25 share price index and the Tel Aviv 100 index rose by about 3.6 percent and 4.2 percent respectively. Most leading share price indices around the world also showed upward trends. The yield curve of government bonds flattened, with 10-year bonds remaining stable, and yields on 2-year to 5-year bonds increasing: yields on unindexed government bonds increased by 30 basis points, and those on indexed government bonds increased by 10–50 basis points. The yield gap between 10-year unindexed Israeli government bonds and US government bonds stayed almost unchanged, at 1.73 percentage points. In the corporate bond market too, prices increased and yields fell. The Tel-Bond 20 index increased by 2.1 percent, and the Tel-Bond 40 index by 3.8 percent. At the beginning of August the Bank of Israel ended the program it started in March 2009 of purchasing government bonds on the secondary market, having bought a total of NIS 18 billion of those bonds, in line with the program. Israel's sovereign risk premium, as measured by the five-year CDS spread, declined from 1.31 percentage points to 1.15 percentage points this month. The CDS spreads of other countries also contracted.
The money supply: In the last twelve months the M1 monetary aggregate (cash held by the public and demand deposits) has grown by 56.1 percent, and the M2 aggregate (M1 plus unindexed deposits up to one year) by 20.5 percent. The steep increase in M1 was due mainly to the public's switching from time deposits to current accounts in light of the low level of interest on the deposits that are included in M2.
The world economy: Economic data published during the last month strengthened the assessment of economic organizations and institutions that activity was starting to stabilize, and that a moderate recovery was expected to start, although at this stage the degree and length of the recovery were unclear. During most of the last month the atmosphere in the financial markets remained positive. In the first half of the month stock exchanges continued to rise, but in the last two weeks there was increased concern over the stability of the economic recovery, especially in China, and against that background the markets fell. Central banks and governments around the world are expected to persist with their expansionary policies, and to start removing their support only gradually. Despite the increase in commodity prices since the end of February, and particularly the increase in energy prices, investment houses on average expect a marked reduction in global inflation in 2009, to 1.6 percent.
The main considerations behind the decision
The decision to increase the interest rate for September by a quarter of a percentage point to 0.75 percent will help return inflation to within the target range and will strengthen the economy’s ability to establish a firm base for the recovery in economic activity, while supporting financial stability. The main considerations behind the decisions are:
  In the last few months, inflation measured over the previous twelve months was above the target range of price stability. A considerable part of the deviation was the result of non-recurring factors (increased tax rates, including VAT, and water prices), but even excluding these elements, inflation was close to the upper limit of the target range. Twelve-months-forward inflation expectations, both those of forecasters and those derived from the capital market, have fallen to around the midpoint of the target range. Nevertheless, it is thought that the reduction in twelve-month inflation expectations is due not only to the continued widening of the output gap, but also to expectations that the Bank of Israel will increase the interest rate in the next few months.
  The most recent data on real activity in Israel strengthen the assessment that there has been a turnaround, although there is great uncertainty regarding the expected rate of growth.
  Interest rates of the leading central banks around the world are expected to remain unchanged till the end of the year, and possibly even to the middle of 2010. However, unlike in Israel, inflation in those countries is expected to remain low both this year and next.
In this situation, the Bank of Israel's decision to increase the interest rate for September by a quarter of a percentage point strikes a balance between the need to moderate inflation and the need to continue to support the recent recovery in economic activity, given that unemployment is expected to continue increasing in the next few months. Setting the interest rate at the low level of 0.75 percent continues to represent an expansionary monetary policy.
The Bank of Israel will continue to monitor Israeli and worldwide economic developments, and will use the instruments available to it to achieve its objectives––price stability, the encouragement of employment and growth, and support for the stability of the financial system.
The minutes of the discussions prior to the above interest rate decision will be published on 7 September 2009.
The decision regarding the interest rate for October 2009 will be published at 17:30 on Thursday, 24 September 2009.