The Bank of Israel increases the interest rate for March 2011 by 0.25 percentage points to 2.5 percent

21.02.2011
 
The Bank of Israel increases the interest rate for March 2011 by 0.25 percentage points to 2.5 percent
 
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Background conditions
Inflation data: The January CPI rose by 0.2 percent, above predictions of the forecasters, who on average expected an increase of 0.1 percent, and above the seasonal path consistent with the achievement of the inflation target, that would require a reduction of at least 0.2 percent. Excluding the effect of government measures introduced in January, the CPI increased by 0.1 percent. Government measures are expected to have a downward effect of 0.05 percent on the February CPI, and 0.06 percent on the March CPI. Inflation in the previous twelve months, excluding housing prices, was 3 percent.
Inflation and interest rate forecasts: The average of forecasters' inflation expectations for the next twelve monthly CPIs remained at 3 percent, the upper limit of the target inflation range. Expectations calculated from the capital market increased again this month, and averaged 3.5 percent, above the upper limit of the inflation target range. Inflation expectations for the medium term are also higher than the target range. Inflation measured over the previous twelve months is expected to be above the upper limit of the target inflation range for most of 2011, and to return to within the range towards the end of the year. Based on the Telbor market (Tel Aviv Inter-Bank Offer Rate), the Bank of Israel interest rate in a year’s time is expected to be 3.7 percent, and on average, forecasters predictions are that it will be 3.6 percent. Most forecasters expect the Bank of Israel to increase the interest rate for March 2011.
Real economic activity: The National Accounts figures for the fourth quarter of 2010 and the latest economic indicators indicate that domestic activity accelerated, led by domestic demand. In the fourth quarter of 2010 growth reached 7.8 percent (annual rate), significantly exceeding the forecasts. That brought growth in 2010 to 4.5 percent. Exports excluding diamonds increased by only 2 percent in that quarter, while civilian imports excluding diamonds, ships and aircraft surged by 20.7 percent. Private consumption increased by a buoyant 9.8 percent, with purchases of durables increasing by about 40 percent. Fixed investment continued along its upward path, and grew by 15.9 percent in the fourth quarter. Investment in residential construction increased by 13.8 percent in the second half of the year. It should be borne in mind, however, that these National Accounts figures are preliminary quarterly estimates that are likely to be updated later. The January composite state-of-the-economy index increased by 0.4 percent, another indication of continued economic growth. Consumer confidence indices remain stable, at a high level. The Bank of Israel Research Department index of the probability of a slowdown, based on Google searches, continues to show a probability below 50 percent.
The Bank of Israel staff forecast at the end of December was that inflation in 2011 will be 2.6 percent, with a gradual increase in the interest rate to about 3.3 percent in the last quarter of the year. The depreciation of the shekel and the increase in commodity prices that occurred in January are likely to lead to an upward revision of the inflation forecast to close to the upper limit of the target inflation range, and to a somewhat faster pace of increases in the interest rate than in the previous forecast. The main risks to real activity and inflation in Israel derive from developments abroad and in the local housing market, and from the realization of geopolitical risks.
The labor market and wages: The faster increase in economic activity in the fourth quarter of 2010 was also reflected in the labor market and in expectations of employment growth in the first quarter of 2011. The Central Bureau of Statistics survey of vacancies shows a 17 percent increase in the number of vacancies in the business sector in January, following reductions in November and December. The number of employee posts of Israelis increased by 4 percent in September–November compared with the previous three months, the nominal wage rose by 0.1 percent, and the real wage fell by 0.9 percent. According to trend data, the unemployment rate remained unchanged in December, at 6.8 percent. Health tax revenues in January were 4.5 percent higher, in real terms, than in January 2010.
Budget data: The government surplus (excluding credit) in January exceeded the level consistent with the seasonal path, and reached NIS 4.5 billion. This was the result of revenues that were about 2 percent higher than the seasonal path, and expenditure that was 8 percent lower than the path. After accounting for the effects of legislative changes and nonrecurring receipts, revenues in January this year were 6 percent higher than those in January 2010. This month several steps were announced that would cut the prices of a number of controlled-price items and would increase the minimum wage. The annual cost of this package is about NIS 1.1 billion. To ensure that neither government expenditure nor the deficit increases, the planned income tax reductions for the upper two income deciles planned for 2012 are being postponed, and an across-the-board cut is being made.
The foreign exchange market: From the previous monetary policy discussion held on January 23 until February 18, the shekel depreciated by 0.2 percent in terms of the nominal effective exchange rate. Following the measures relating to the foreign currency market announced by the Bank of Israel and the Ministry of Finance and in light of the events taking place in Egypt, the shekel weakened at the beginning of the period, but it strengthened again with the announcement of the January CPI and the growth figures for the fourth quarter of 2010 that significantly surpassed expectations. In the period from January 23 to February 18 the shekel appreciated by 0.35 percent against the dollar (similar to the changes in the major currencies), and depreciated by about 0.3 percent against the euro.
The capital and money markets: Between the monetary policy discussions of January 23 and February 18, the Tel Aviv 25 index remained steady, after fluctuations in trade that were heavily influenced both by geopolitical developments and by the figures on growth in Israel. In this period stock markets around the world showed a mixed trend––share price indices in the advanced economies performed strongly, while those in emerging market economies declined. In Israel yields on local currency government bonds increased by between 16 and 23 basis points (b.p.) along the entire curve, similar to the worldwide trend. The increase in yields was supported by the geopolitical situation. The CPI-indexed bonds yield curve became steeper: long-term yields increased by between 12 b.p. and 18 b.p., while short-term yields dropped by about 20 b.p., reflecting an increase in inflation expectations. The makam yield curve reflected an increase in yields along the entire curve of 16–23 b.p., against the background of the increase in the interest rate last month and expectations that the interest rate would increase sooner than previously expected. The yield gap between Israeli and US unindexed 10-year government bonds did not show any significant change this month, and remained at 140 b.p. In the corporate bond market the Tel-Bond indices reacted to the events in Egypt as did other investment channels––at the beginning of the period (January 23 to February 18) they fell, and then strengthened, so that over the period as a whole they did not change. At the same time, yield spreads narrowed, particularly on low-rated bonds. Israel's sovereign risk premium as measured by the five-year CDS spread increased considerably this month, from 115 b.p. to 145 b.p., in light of the developments in Egypt.
The money supply: In the last twelve months the M1 monetary aggregate (cash held by the public and demand deposits) increased by 8.9 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 5.6 percent.
The credit market:Total outstanding business sector credit increased by 0.6 percent in December, to NIS 759 billion. In the whole of 2010 this credit grew by 3 percent. Outstanding credit to households decreased by 0.4 percent in December 2010, and in the year as a whole it increased by 8.9 percent. The housing element of this balance increased by 1 percent in December, and in the whole of 2010 it increased by 11.4 percent. Total new mortgages advanced in January declined by 14.5 percent, following their 9 percent increase in December. Despite the decline in January, the monthly uptake rate of new mortgages remains high.
The housing market: The high rate of house price increases continued. House prices––which are presented in the Central Bureau of Statistics survey of house prices but are not included in the CPI––increased in November–December at a rate of 1.3 percent a month, following their increase of 1.4 percent a month in October–November. House prices continued to increase at a high rate, and in the last twelve months they increased by 17.5 percent. The housing price index, which is based mainly on renewed rental contracts and which is included in the CPI, rose by 0.3 percent in January, the same as its rise in December. In the last twelve months the housing price index increased by 5.9 percent.
The global economy: : Data published this month paint a positive picture of global economic activity. The latest indicators show continued rapid growth in the emerging markets, and an increased rate of growth in the US. In the eurozone there are firmer expectations of increased demand this year, particularly in France and Germany. The UK stood out negatively with a slowdown in growth in the fourth quarter of 2010. The latest global indicators were better than previously expected, resulting in an upward revision of growth forecasts. In January the IMF updated its global growth forecast for 2011 to 4.4 percent (from 4.2 percent), which incorporated a marked increase in the forecast US growth figure from 2.3 percent to 3 percent. The upheaval in the Arab world continued this month, and increased the level of geopolitical uncertainty regarding the Middle East. The demonstrations that started in Tunisia in December spread to other Arab countries. In Egypt the pressure brought about the resignation of the President. Commodity prices continued to increase this month. Inflation in the US increased last month, but remains low, while in the eurozone it exceeded the target again this month. Inflation in the emerging market economies continues to be high, and in China and India this led to increases in interest rates. The expected timing of increased interest rates in the US was brought forward somewhat.
The main considerations behind the decision
The decision to increase the interest rate for March by 25 basis points to 2. 5 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 rate of increase in 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.
  The publication of the January CPI brought the rate of inflation over the previous twelve months to above the upper limit of the target inflation range. Forecasters’ inflation expectations for one year forward remained stable, close to the upper limit of the target range, and expectations calculated from the capital market continued to rise and reached an average of 3.5 percent last month. At the same time, the upward trend in inflation expectations for the longer term derived from the capital market persists.
  Economic indicators published this month show that activity expanded at a faster pace, led by domestic demand. The increased activity was reflected by the high growth rate in the fourth quarter, led––according to the National Accounts figures––by manufacturing activity, and was reflected also by the labor market and government tax revenues. Data on global economic activity were also positive, pointing to continued rapid growth in the emerging market economies and a certain acceleration in economic growth in the US economy.
  The steep increase in house prices continued; in the last twelve months they have risen by 17.5 percent. Although there was a drop in the volume of new mortgages in January, the volume of housing loans is still expanding rapidly.
  The decision to increase the interest rate was taken despite the fact that interest rates of the central banks in the major advanced economies are at low levels, and the markets reflect expectations that they will not rise in the near future. Nevertheless, the expected timing of an increase in the Fed interest rate has been brought forward. Furthermore, some central banks in economies that are already showing relatively fast rates of growth continued the process of raising their interest rates again last month.
The Bank of Israel will continue to monitor developments in Israel's economy and the global economy and in the financial markets. The Bank 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 assets market, and especially in the housing market.
The minutes of the discussions prior to the above interest rate decision will be published on March 7, 2011.
The decision regarding the interest rate for April 2011 will be published at 17:30 on Monday, March 28, 2011.