The Bank of Israel increases the interest rate for August 2010 to 1.75 percent

26.07.2010
 
The Bank of Israel increases the interest rate for August 2010 to 1.75 percent
 
The Bank of Israel announces that the interest rate for August 2010 will be increased by 25 basis points to 1.75 percent.
Background conditions
Inflation data: The June CPI rose by 0.3 percent, within the range of forecasts of 0.1 percent to 0.4 percent. The housing index rose by 0.6 percent, and since the beginning of the year it has risen by 2.2 percent. Inflation in the last twelve months, 2.4 percent, was within the target range; adjusting for the effects of changes in indirect taxes and surcharges, inflation was 2.2 percent.
Inflation and interest rate forecasts:The Bank of Israel and the private forecasters expect inflation measured over the previous twelve months to continue to decline in the next few months. However, forecasters' expectations of the rate of inflation in the next twelve months' indices (July 2010 to June 2011) rose significantly, from an average of 2.6 percent at the end of June to an average of 3.2 percent in mid-July. Inflation expectations derived from the capital market continued to move around the upper limit of the inflation target. In the next three months the forecasters, on average, expect inflation of 1 percent. With regard to the Bank of Israel interest rate, expectations calculated from the capital market are that the interest rate a year hence will be 2.5 percent. The forecasters, on average, expect an increase of 0.4 percentage points in the interest rate in the next three months; they expect the rate to be 2 percent at the end of 2010, and 2.7 percent in a year's time.
Real economic activity: Indicators of economic activity that became available during the past month support the assessment that business activity continued to grow in the second quarter of 2010. Most of the indicators present a positive picture but some suggest the possibility that growth slowed, perhaps significantly, during the second quarter. Increased activity in the second quarter was reflected in the data of the Bank of Israel's Companies Survey and in the continued increase in the index of manufacturing production. That said, there is doubt whether the rate of recovery evident till recently will continue, due to the decline in the Purchasing Managers Index, the standstill in exports in the second quarter and expectations that this will continue (according to the Companies Survey), the downward revision of the composite state-of-the-economy indices for both March and April to 0 percent, and the minimal rise of 0.1 percent in the June index. Gross domestic VAT revenue in the last three months also declined by 5 percent compared with the previous three months, but these revenues are still 11 percent higher than in the equivalent period last year.
The labor market and wages: Most of the sources that had indicated a slowdown in the recovery in the labor market in the first quarter showed a return to a more rapid recovery in the second quarter. These include in particular the unemployment trend data for June, which shows a decline in unemployment to 6.5 percent, and also the Manufacturers Association survey of expectations; the Bank of Israel Companies Survey, with reports of a more significant increase in employment in the second quarter; the Central Bureau of Statistics survey of vacancies, which shows a faster increase in the number of employees and in the number of vacancies in April–June, in contrast to the moderation in the rate of increase reported in the survey for the first quarter; and. Although the real and nominal wage fell by 2 percent in April from their March levels due to the decline in the business sector wage, this followed a marked increase in the first quarter. The number of employee posts increased in February to April by 2.5 percent in annual terms, relative to the previous three months.
Budget data: From the beginning of 2010 until June the domestic deficit was NIS 8.7 billion, compared with NIS 15.5 billion in the equivalent period in 2009. On the basis of the current data, the deficit in 2010 is expected to be about 4 percent of GDP. At the beginning of July, the government approved the proposed budget for the next two years (2011–12), which is consistent with a decline in the deficit to 3 percent and 2 percent of GDP in 2011 and 2012 respectively.
The foreign exchange market: From the previous monetary policy discussion held on June 27 until July 25, the shekel appreciated by 0.4 percent against the dollar, at a time when most currencies worldwide strengthened markedly against the dollar; the shekel depreciated by 4.6 percent against the euro, in line with the trend in the international markets. In terms of the nominal effective exchange rate, the shekel weakened by about 2.1 percent, as a result of its marked depreciation against the euro.
The capital and money markets:Between the monetary policy discussions of June 27 and July 25, the Tel Aviv 25 index rose by 3 percent, and the Tel Aviv 100 index by 1.8 percent, in line with the rises in many stock markets around the world during that period. Yields on Israel government bonds declined this month along both the nominal and indexed yield curves, particularly at the short end of the nominal term structure. The yield gap between Israeli and US unindexed 10-year government bonds widened this month to 160 basis points (b.p.), as a result of sharper declines in yields in the US. The positive trend in corporate bond issues was reflected in a considerable increase in issues in July, mainly of indexed bonds. The Tel-Bond 20 index rose by 1.23 percent over the period, and the Tel-Bond 40 index by 1.74 percent. Israel's sovereign risk premium, as measured by the five-year CDS spread, remained unchanged this month at 115 b.p., in line with the trend in risk premiums around the world.
The money supply: The M1 monetary aggregate (cash held by the public and demand deposits) fell by 2 percent in June, following its 1 percent increase in May; in the last twelve months it increased by 9 percent. The M2 aggregate (M1 plus unindexed deposits of up to one year) declined by 1.5 percent in June, following its 0.4 percent rise in May; in the last twelve months it increased by 2.3 percent.
The credit market: Total outstanding business sector credit remained steady in May at NIS 739 billion, following its 0.8 percent increase in April. Bank credit accounted for NIS 389 billion, a decline of 0.6 percent from its April level, compared to an increase of 1.1 percent from March to April. Outstanding nonbank credit (corporate bonds and nonbank loans) declined slightly in May to NIS 218 billion. Between the beginning of 2009 and May 2010 credit to households, led by housing credit, has increased by a cumulative 10.6 percent, in line with the increases of 6.5 percent in 2007 and of 7 percent in 2008. The rate of new mortgages taken in the previous twelve months continues to rise. The total value of mortgages given in the first half of 2010 was 52 percent greater than that in the first half of 2009, partly due to the increase in apartment prices.
The housing market: House prices, which are measured by the Central Bureau of Statistics survey of house prices (which are not included in the CPI) increased by 1.2 percent in April, continuing the increase evident in the last sixteen months. According to the survey, house prices have risen by 21 percent in the last year. A recent examination of house prices shows that their level is not significantly different from that compatible with the fundamental economic conditions. The rate of increase, however, also in April, continues to be very rapid, and if prices continue to rise at the current pace they are likely to deviate from the level consistent with the basic economic conditions.
The global economy: There are growing signs that the pace of the global recovery is slowing. The background to the slowdown in growth is weaker-than-expected macroeconomic data from the US, the ending of government rescue programs, contractionary measures introduced in the Chinese economy, the continuing uncertainty over the fiscal crisis in some European countries, and policies to reduce deficits in those countries.. Forecasts this month tended to predict lower levels of global growth than forecasts earlier in the year. Nonetheless, global growth is expected to continue in the next few months, mainly due to the very low interest environment and continued rapid growth in East Asia. In light of the high rate of growth in the first quarter of 2010, the IMF revised its forecast of global growth in 2010 from 4.2 percent to 4.6 percent , and left its forecast for 2011 unchanged. In contrast the foreign investment houses began to lower their forecasts of growth in various economies. Capital markets continued to be very volatile. Trade in shares was characterized by rising prices, against the background of some easing of the European debt crisis and buoyant company reports for the second quarter. The investment houses expect the positive atmosphere in capital markets to continue in the short term. Global inflation remains low, against the background of the apparent slowdown in the rate of global recovery, the general stability of commodity prices, and the output gaps in the advanced economies. Against this background, the leading central banks' transition to increases in interest rates has been deferred further. Some other central banks, however, increased their interest rates this month, and further increases are expected in the coming months.
The main considerations behind the decision
The decision to increase the interest rate for August to 1.75 percent is consistent with the gradual process of returning the interest rate to a more 'normal' level, intended to position inflation firmly within the target range, and to contribute to the further recovery of economic activity, while supporting financial stability. The path of the interest rate will be determined in accordance with the inflation environment, the entrenchment of growth in Israel and globally, the monetary policies of the leading central banks, and in light of developments in the exchange rates of the shekel. At the current level of the interest rate, monetary policy continues to be expansionary.
  Inflation forecasts of the Bank of Israel and of the private forecasters and expectations derived from the capital market for one year ahead are around the upper limit of the target inflation range. The Bank of Israel's assessment of inflation in the next twelve months was revised upwards in light of the weakness of the shekel (in terms of the effective exchange rate) in the last month, the continued increase in house prices, and the planned hikes in indirect taxes.
  Housing prices and the housing index (rents) are continuing to increase rapidly, together with a rapid expansion of housing credit.
  Data on real activity that became available this month present a mixed picture. Some indicate continued expansion and a further decline in unemployment, while others point to a slowdown in activity, and particularly in exports. An analysis of the whole range of data leads to the assessment that positive growth will continue in accordance with the Bank's previous forecasts, with a gradual contraction of the output gap.
  Interest rates of the central banks of the major advanced economies are at very low levels, and in light of recent developments are expected to remain so for some considerable time. That said, central banks in several countries that are already growing relatively rapidly continued with the process of increasing their interest rates last month too, and are expected to continue to do so in the near future.
The Bank of Israel will continue to monitor Israeli and worldwide economic and financial developments, and will use the instruments available to it to achieve its objectives of 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 August 9, 2010.
The decision regarding the interest rate for September 2010 will be published at 17:30 on Monday, August 23, 2010