The Bank of Israel leaves the interest rate unchanged at 3 percent for May 2011

24.04.2011
 
The Bank of Israel leaves the interest rate unchanged at 3 percent for May 2011
 
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Background conditions
Inflation data: The inflation rate, measured over the previous twelve months, continued to increase, and in March reached 4.3 percent. The CPI (Consumer Price Index) excluding the housing price component was unchanged in March, and rose by 3.6 percent in the previous twelve months. The CPI increased by 0.2 percent in March, slightly less than the average forecast, and in line with the seasonal path consistent with the achievement of the inflation target. This was in contrast to the previous four months in which the CPI change was above the upper limit of the path. However, it is important to note that this is a single figure, and it is too early to tell if it marks a turning point.
Inflation and interest rate forecasts: The average of forecasters' inflation expectations for the next twelve monthly CPI readings was unchanged from the previous month at 3.1 percent, slightly above the upper limit of the target inflation range. Inflation expectations calculated from the capital market declined, on average, to 3.1 percent in April. This decline took place against the background, among other things, of the 0.50 percentage point interest rate hike by the Bank of Israel last month. It appears that medium-term and long-term inflation expectations were also impacted by the rate hike last month, and those expectations fell this month, so that most of the curve is now within the inflation target range. Forecasters' predictions and the Bank of Israel Research Department staff forecast are that the CPI rise for April will be high, with an average of 0.8 percent, in line with the seasonal path consistent with the mid-point of the inflation target range. The inflation rate for the preceding twelve months is expected to remain above the target range during the rest of 2011, and it is expected to decline at the beginning of 2012 to the upper limit of the target range. Based on the Telbor market (Tel Aviv Inter-Bank Offered Rate), the Bank of Israel interest rate in a year’s time is expected to be 4.4 percent, and on average, forecasters' predictions are that it will be 4.2 percent. Both figures represent a rise in interest rate forecasts compared with the previous month. Most forecasters expected the Bank of Israel to leave the interest rate unchanged for May 2011.
Real economic activity: Economic indicators that became available this month show that domestic activity continued to expand, and point to continued expansion in the second quarter. Figures compiled so far from the Bank of Israel's Companies Survey for the first quarter show that in the first quarter company activity continued to grow in most sectors. According to the survey, companies in all sectors expect growth to continue in the second quarter as well. Monthly figures point to continued growth in industrial production and in revenue in the trade and services sector. The March composite state-of-the-economy index rose by a strong 0.5 percent, continuing the strong gains of previous months. With respect to foreign trade, the rapid pace of growth of goods exports and of goods imports continued in the first quarter. Analysis of data on real economic activity points to the fact that growth in the first quarter was led by exports. This, despite the continued appreciation of the shekel. In contrast, however, the Purchasing Managers Index indicates a drop in domestic demand for the second consecutive month, and the Bank of Israel Research Department index of the probability of a slowdown in domestic demand, based on Google searches, increased to about the 50 percent threshold.
The Bank of Israel staff forecast which was updated this month, is that inflation in 2011 will be above the upper limit of the target inflation range, and will decline to the upper limit toward mid-2012, with the interest rate increasing gradually to about 4.4 percent in a year’s time. This month, the Research Department updated its GDP (Gross Domestic Product) growth forecast for 2011 to 4.5 percent, from an original forecast of 3.8 percent, and the unemployment rate for the year is expected to be 6.1 percent on average. The Research Department also published a forecast of 4 percent growth, with an average unemployment rate of 5.9 percent, for the full year of 2012. The main factors which can change the forecasts for real activity and inflation in Israel are developments in the global economy, including increases in commodity and oil prices, developments in the local housing market, the realization of geopolitical risks, and a possible increase in wage pressures in the public sector. At the same time, a boost in growth of world trade is likely to contribute to export volume. The recent appreciation of the shekel may help bring inflation to within the target range earlier, which may moderate the pace of interest rate hikes.
The labor market and wages: The number of claimants for unemployment benefits fell consistently from January to March, and its average level is lower than the average level in the second half of 2010. The labor force survey for the fourth quarter of 2010 showed that the number of employed persons rose throughout the year in most sectors of the economy. The unemployment rate was 6.6 percent in the fourth quarter of 2010, and according to trend figures the unemployment rate in January was 6.1 percent. Nominal wages rose in November–January by 1.9 percent and real wages rose 0.5 percent compared with their levels in August–October. Health tax receipts in February 2011, which provide an indication of wage payments in that month, are 8.6 percent higher, in nominal terms, than their level in February 2010.
Budget data: Government expenditure in January–March was 6.8 percent lower than the seasonal level consistent with full expenditure of the budget. Since the beginning of the year, the government's overall cumulative surplus in the budget totaled NIS 2 billion, about NIS 4.5 billion higher than the seasonal path consistent with remaining below the deficit ceiling. Tax revenues in January–March, after accounting for the effects of legislative changes and nonrecurring receipts, were 9.1 percent higher, in real terms, than in the first three months of 2010–direct tax revenues were 11.6 percent higher, and indirect tax revenues were 7.6 percent higher.
The foreign exchange market: From the previous monetary policy discussion held on March 27, through April 20, the shekel appreciated by 3.7 percent against the dollar, and appreciated by 1.9 percent against the euro. In nominal effective exchange rate terms, the shekel strengthened 2.5 percent. Despite the interest rate hike in Israel, the shekel's strength was similar to the strength of currencies of other fast growing economies around the world, against a background of continued Bank of Israel intervention in the foreign currency market.
The capital and money markets:Between the monetary policy discussions of March 27 and April 20, most Tel Aviv Stock Exchange share price indices rose. This was in contrast to the general trend in developed markets, but in line with developments in several emerging markets. The Tel Aviv 25 Index rose 2.5 percent and is at all-time record high levels, and the Tel Aviv 100 Index rose 1.7 percent. Yields on government bonds increased in this period, against the background of the latest increase in the interest rate, expectations of a faster rate of increase in the interest rate, and geopolitical uncertainty. Over the period, the yield on makam increased along the entire curve by about 20 basis points. The decline in nonresidents’ activity in the makam market halted this month, as foreign investors reentered this market. Yields on local currency bonds increased primarily in short-term maturities by about 20 basis points. Yields on CPI-indexed government bonds rose sharply by about 10–50 basis points, as the yield curve flattened somewhat, reflecting a sharp drop in inflation expectations derived from the capital market. The yield gap between Israeli unindexed 10-year government bonds and US 10-year Treasury notes was unchanged during the period surveyed, and stood at 186 basis points. The corporate bond market saw renewed growth in the pace of issues compared with February and March. The CPI-indexed Tel-Bond indices showed prominent drops of about 1.5%, against the background of the rise in the interest rate in March; the Tel-Bond Shekel Index was little changed. Israel's sovereign risk premium as measured by the five-year CDS spread continued to fall this month, and reached 142 basis points, compared with 153 basis points at the end of last month.
The money supply: In the twelve months ending in March the M1 monetary aggregate (cash held by the public and demand deposits) increased by 5.2 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 7.6 percent.
Developments in the market for housing credit: The balance of outstanding housing credit increased in the twelve months ending in February by 12.8 percent. Forty-eight percent of housing loans given in March were unindexed, variable rate loans, and in all, about 80 percent of the loans granted were variable rate (indexed and unindexed), similar to previous months. The amount of mortgages granted in the previous twelve months continued to be high––about NIS 50 billion. The rates of interest on mortgages of all types increased again this month, against the background of the recent increases in the Bank of Israel interest rate, among other things.
The housing market:House prices––which are presented in the Central Bureau of Statistics survey of house prices but are not included in the CPI––continued to increase, and in January–February they increased at a rate of 1.7 percent a month, following their increase of 0.8 percent a month in December–January. The annual pace of rises in house prices continues to be high, and in the last twelve months house prices increased by 16.1 percent. The housing price index, which is based mainly on renewed rental contracts and which is included in the CPI, rose by 0.6 percent in March. In the last twelve months the housing price index increased by 6.4 percent, similar to the previous month.
The global economy: : The global economic recovery continued in the past month as well, and was based primarily on the strong growth in Asian economies, on the noticeable improvement in major European economies, and on continued growth in US employment and personal consumption. The economic expansion worldwide was reflected as well in the continued rise in global commodities exports in the first quarter, as well as in consecutive increases in industrial production indices in the US, Euro bloc, Japan, and other countries. In addition, a move from government demand to private demand continued, and there was reduced concern that the end of fiscal expansion which followed the crisis will lead the global economy to renewed contraction. On the other hand, the main risks to the global economy are the continued rise in commodity prices, continued instability in the Middle East, uncertainty regarding the economic consequences of the earthquake in Japan, the debt crisis in some European countries which worsened this month, and increased attention to US debt and deficit levels by one of the credit rating agencies. This month, the International Monetary Fund (IMF) left its growth outlooks unchanged but emphasized its concerns about the downside risks to these forecasts. With an eye to rising prices, and the growing pace of inflation, central banks in emerging markets continued to react with monetary tightening policies, and the ECB (European Central Bank) joined the trend this month.
The main considerations behind the decision
The decision to leave the interest rate for May unchanged at 3 percent is consistent with the process of returning the interest rate to a more normal range 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.
  Inflation expectations for the next twelve months derived from the capital market declined, due in part to the increase in the interest rate for April. However, at 3.1 percent, similar to the average of the forecasters’ expectations which did not change this month, the expectations are still above the upper limit of the inflation target range. Inflation expectations for periods longer than a year also declined, and most are now within the target range.
  The recent appreciation of the shekel and the recent increases in the interest rate are expected to moderate the rate of inflation in the coming months.
  Indicators of economic activity published this month support the assessment that the rapid expansion of activity and demand continued in the first quarter of 2011. The Bank of Israel staff forecast was updated, and now predicts GDP growth of 4.5 percent in 2011, compared with the previous forecast of 3.8 percent. The global economy is continuing along the path of recovery. Nevertheless, there are several risks that are still raising the level of uncertainty regarding future global growth.
  House prices continued to increase this month, and in the last twelve month have risen by 16.1 percent. The balance of housing credit increased by 12.8 percent in the twelve months to February 2011. About 80 percent of housing loans granted in March were at floating interest rates. Against the background of these developments, the Bank of Israel is considering the introduction in the near future of additional measures in the housing credit field.
  Central bank interest rates in the major advanced economies are still low. The ECB, however, recently increased its interest rate by 25 basis points, and against the background of the acceleration in inflation in emerging market economies, a relatively large number of central banks are continuing to raise their interest rates and are introducing other contractionary measures. The interest rate differential between economies with relatively rapid growth rates, including Israel, and the advanced economies presents policy makers in the former with a serious challenge––how to balance the domestic pressures to increase the interest rate with the effect of such an increase on the appreciation of their currencies and its effect on their exports, and hence on economic activity.
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 May 9, 2011.
The decision regarding the interest rate for June 2011 will be published at 17:30 on Monday, May 23, 2011.