The Bank of Israel increases the interest rate for October 2010 by 25 basis points to 2 percent

The Bank of Israel increases the interest rate for October 2010 by
25 basis points to 2 percent
The Bank of Israel announces that the interest rate for October 2010 will increase by 25 basis points to 2 percent.
Background conditions
Inflation data: The August CPI rose by 0.5 percent, above the range of forecasters' predictions of an increase of between 0 percent and 0.3 percent. The housing index, which increased by 1.7 percent, was again one of the main causes of the rise this month. Inflation in the last twelve months was 1.8 percent, within the inflation target range, for the third month in succession. Excluding the housing index, the CPI rose by only 0.7 percent in the last twelve months.
Inflation and interest rate forecasts:Inflation expectations derived from the capital market and those of the private forecasters remained steady this month at slightly below the upper limit of the target range. Inflation measured over the previous twelve months is expected to remain around the midpoint of the target inflation range in the next few months. 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 2.8 percent, and the forecasters, on average, expect it to be 2.7 percent, levels similar to those in the previous month. The forecasts referred to by the Bank of Israel on average predicted an increase of 0.21 percentage points in the interest rate for October.
Real economic activity: Initial data for the third quarter of 2010 present a mixed picture. Initial findings from the Bank of Israel Companies Survey for the third quarter suggest that activity continued to grow at a rate similar to that in the first half of the year; manufacturing production and sales of the principal industries continued to increase in July; the composite state-of-the-economy index, which is based partly on the last two components, i.e., manufacturing production and revenue of the principal industries, and on foreign trade data, rose moderately in August, following the increases in the previous months. Monthly foreign trade data, however, and figures of government tax revenues, were stable, possibly even showing a slowdown, although it is too soon to determine whether this represents a turning point in the rate of increase in activity. The overall picture obtained from the data appears to indicate that the output gap continues to decline.
The Bank of Israel staff forecast is that inflation in the next twelve months will be 2.5 percent, with a gradual increase in the interest rate during that time to about 2.7 percent. The updated macroeconomic forecast of the Research Department is that GDP growth in 2010 will be about 4 percent.
The labor market and wages: The labor market improved very considerably in the period from the beginning of 2009 to the second quarter of 2010. Labor market data this month give conflicting information: the August figures show an increase in the number of claims for unemployment benefits and a marked fall in the number of vacancies, as shown by the Central Bureau of Statistics Job Vacancies survey. In contrast, the Manpower Survey for the second quarter showed a continued decline in the rate of unemployment to the low level of 6.2 percent. The ongoing contraction of the economy's excess production capacity is consistent with the rising trend in the nominal wage and the real wage in the last few months.
Budget data: From the beginning of 2010 until August the domestic deficit was NIS 12 billion, compared with NIS 16.3 billion in the equivalent period in 2009. On the basis of the current data, the deficit in 2010, excluding credit, is expected to be 4 percent of GDP, or even slightly lower.
The foreign exchange market: From the previous monetary policy discussion held on August 22 until September 24, the shekel appreciated by 2.4 percent against the dollar, and depreciated by 2.1 percent against the euro, in line with the trend in the international markets. In terms of the nominal effective exchange rate, the shekel strengthened by about 0.3 percent. In order to counteract the strengthening of the yen, the Bank of Japan intervened in the foreign exchange markets for the first time in six years.
The capital and money markets:Between the monetary policy discussions of August 22 and September 24, the Tel Aviv 25 index rose by 5.6 percent, and the Tel Aviv 100 by 6.2 percent, and they are currently close to their previous peak levels. Most of the leading share price indices around the world also rose in this period. Yields on Israel government bonds increased this month along both the nominal and indexed yield curves. The yield gap between Israeli and US unindexed 10-year government bonds widened this month. There was renewed activity in corporate bond issues: the low rates of interest led to a steep increase in the extent of new issues, as companies tried to take advantage of cheap finance and the boom in funds that specialize in corporate bonds. The Tel-Bond 20 and the Tel-Bond 40 indices declined by about 0.3 percent. Israel's sovereign risk premium as measured by the five-year CDS spread fell slightly this month to about 121 basis points.
The money supply: The M1 monetary aggregate (cash held by the public and demand deposits) dropped by 1.4 percent in August, following its 3 percent increase in July, which was due partly to the strong seasonal factor. In the last twelve months M1 increased at a low rate of 1.4 percent. The M2 aggregate (M1 plus unindexed deposits of up to one year) decreased by 1.3 percent, in August, following its 0.3 percent increase in July; in the last twelve months it increased by 0.5 percent.
The credit market: Total outstanding business sector credit increased slightly in July to NIS 746 billion, following its 1 percent increase in June. Bank credit accounted for NIS 394 billion, an increase of 1 percent from its June level. Outstanding nonbank credit (corporate bonds and nonbank loans) remained steady in July, at about NIS 220 billion. Credit to households increased by 1.2 percent in June, to NIS 329 billion. New mortgages were 7 percent higher in August than in July, when they dropped by 10 percent; their level in August was significantly above their average level in 2009. The rates of interest on fixed- and floating-interest indexed mortgages continued to fall, while interest rates on floating-rate mortgages indexed to prime increased following the increase in the Bank of Israel interest rate for August.
The housing market: House prices, as shown in the Central Bureau of Statistics survey of house prices (which are not included in the CPI) continued to rise, albeit more slowly than previously: in June/July they increased by 0.7 percent, following their increase of 2.2 percent in May/June. House prices have risen by 20 percent in the last twelve months. The housing component in the CPI, which is based mainly on renewed rental contracts, continued its upward trend, and rose by 1.7 percent in August. Some of this rise may be a reaction to the continued steep increases in house prices.
The global economy: The economic recovery world wide continued in the second quarter of 2010, but some recent developments have given rise to concerns over the sustainability of worldwide growth, and it is assessed that the growth rate will slow in the second half of the year. The recovery is not uniform: growth in the leading advanced economies is fragile, with stronger growth in the emerging market economies. Concern over a return to recession eased, however, and growth is expected to continue, albeit at a slow rate, below the long-term trend levels. Against this background forecasters revised their growth forecasts downwards this month. The financial markets were highly volatile, against the background of the mixed macroeconomic data and the high level of uncertainty. Overall inflation indices rose following the increase in commodity prices, but inflation is still low and is expected to remain so in the major economies, particularly in light of excess production capacity. In some economies, however, inflationary pressure is still evident. On the monetary side, in light of the high level of uncertainty and the remaining signs of weakness in the global economy, the leading central banks are expected to keep their interest rates low, and to continue with quantitative easing. That said, the central banks of Canada and Sweden increased their interest rates by a quarter of a percentage point this month. On the fiscal side, the large-scale easing is expected to moderate, due to large deficits.
The main considerations behind the decision
The decision to increase the interest rate for October to 2 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 support the further recovery of economic activity, while maintaining financial stability. The path of the interest rate is not pre-determined, but is set in accordance with the inflation environment, growth in Israel and globally, the monetary policies of the leading central banks, and developments in the exchange rates of the shekel. At the current level of the interest rate, monetary policy continues to be expansionary.
  Inflation in the last twelve months was close to the midpoint of the target inflation range, but inflation expectations calculated from the capital market for one year ahead and those of the private forecasters remain in the area of the upper limit of the target inflation range, with the interest rate expected to rise to about 2.7 percent in a year's time.
  House prices are still increasing steeply, and housing loans continue to expand rapidly reflecting the low rate of interest and the slow adjustment of the supply of houses. The housing component of the CPI is still rising, at an even slightly faster pace than in recent months.
  Most recent indicators of real economic activity point to continued rapid expansion in the third quarter––in particular, initial data from the Companies Survey for the third quarter, which suggest that economic activity continued to expand at a similar rate to that in the first half-year, the steep decline in the rate of unemployment in the second quarter, and first signs of increases in the real and nominal wage indicate the continued contraction in Israel's output gap.
The decision to increase the interest rate was taken despite the fact that 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. Nevertheless, 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, including keeping a close watch on developments in the housing market, and specially on house prices.
The minutes of the discussions prior to the above interest rate decision will be published on October 11, 2010.
The decision regarding the interest rate for November 2010 will be published at 17:30 on Monday, October 25, 2010.