The Bank of Israel leaves the interest rate for July 2011 unchanged at 3.25 percent

27.06.2011
 
The Bank of Israel leaves the interest rate for July 2011 unchanged at 3.25 percent
 
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Background conditions
Inflation data:The inflation rate over the last 12 months was 4.1 percent, above the upper limit of the target inflation range (of 1–3 percent a year). The Consumer Price Index (CPI) rose by 0.5 percent in May, in line with the forecasts and at the upper limit of the seasonal path consistent with achieving the inflation target. The continued rapid increase in housing and food prices, which continued this month, contributed to the increase in the index. The index excluding housing rose by 0.2 percent in May. The seasonally adjusted monthly rise in the index, particularly the index excluding owner-occupied housing, in the last three months was significantly slower than that in the previous three months.
Inflation and interest rate forecasts: Inflation expectations for the next twelve months as calculated from the capital market and those of forecasters re-entered the target inflation range, and stood at 2.9 percent, slightly below the upper limit of the range. The decline in expectations is apparently due to several developments that have served to moderate inflation: the appreciation of the shekel in the last few months, the fall in commodity prices, and the last three CPIs published, that are consistent with meeting the inflation target. Medium-term inflation expectations are within the target range. Based on the Telbor (Tel Aviv Inter-Bank Offered Rate) market, the Bank of Israel interest rate one year from now is expected to be 4 percent, and the average of forecasters' predictions is that it will be 4.3 percent. All the forecasters who updated their forecasts following the publication of the May CPI expect the Bank of Israel to leave the interest rate for July unchanged.
Real economic activity: Economic indicators that became available this month show that economic activity continued to expand in the second quarter, albeit more slowly than in the first quarter. The composite state-of-the-economy index for May increased 0.3 percent, and the average change in the index over the past three months of 0.25 percent is lower than the average monthly change (0.5 percent) in the year and a half that preceded them. Partial data for the second quarter (April and May) point to a 1.5 percent decline in manufactured goods exports in the second quarter compared with the first quarter, in parallel to a decline in the volume of world trade in April. With that, a number of indicators point to continued growth. The second estimate of the National Accounts data for the first quarter shows a picture similar to that shown by the first estimate—an annualized GDP growth rate of 4.8 percent, and business product growth of 5.5 percent. At the beginning of this month the Bank of Israel revised its growth forecast for 2011 upwards, to 5.2 percent (compared with 4.5 percent in the previous forecast). The Central Bureau of Statistics trends survey reflects positive expectations of activity in the principal industries in the next few months. Consumer confidence indices declined a little this month but are still at a high level, expressing an optimistic view of economic activity.
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 that it will decline to within the range in the first quarter of 2012. The interest rate is expected to increase gradually to about 4.1 percent in a year’s time (the average rate for the second quarter of 2012). Balance of risks: The main factors which could alter the forecasts for real activity and inflation in Israel are developments in the global economy, specifically a possible deterioration of the debt crisis in Europe, the realization of geopolitical risks, and commodity and oil prices.
The labor market and wages: Labor market data indicate a continued expansionary trend in employment and a drop in unemployment, with a moderate increase in wages. According to trend figures for April, the percentage of unemployed continued to fall, and reached 5.8 percent of the civilian workforce. The nominal wage increased in January–March by 0.8 percent compared with the level in the previous three months, while the real wage dropped by 0.9 percent (seasonally adjusted). Health tax receipts in May, which provide an indication of wage payments in that month, were 7.6 percent higher, in nominal terms, than in May 2010. The minimum monthly wage is scheduled to increase from NIS 3,900 to NIS 4,100 at the beginning of July.
Budget data: Tax revenues in January–May were 7.4 percent higher, in real terms, than the corresponding period last year. Domestic expenditure in the first five months of the year resulted in a cumulative surplus of 0.1 percent of GDP, compared with a deficit of 0.5 percent of GDP in the corresponding period of 2010. Tax collection is expected to be higher than the forecast on which the budget was based, and the annual deficit is expected to be lower than the legally prescribed ceiling (3 percent of GDP), even assuming full expenditure of the budget.
The foreign exchange market: From the previous monetary policy discussion held on May 19, through June 24, the shekel appreciated by 1.3 percent against the dollar, in line with the trend around the world, and by about 1.6 percent against the euro. The strengthening of the dollar against the other major currencies resulted from very weak macroeconomic figures and increased concern over the debt crises in Europe. In terms of the nominal effective exchange rate the shekel strengthened by about 1.2 percent.
The capital and money markets:Between the monetary policy discussions of May 19 and June 24, most Tel Aviv Stock Exchange share price indices fell, in line with the general trend abroad. The Tel Aviv 100 Index fell by 6.6 percent. Yields on local currency government bonds declined by 5–12 basis points (b.p.), mainly in the medium term. Yields on CPI-indexed government bonds showed a mixed trend, rising 5–35 basis points in the short term while medium- to long-term yields were stable and even declined a little. This came against the background of global weakness and a decline in inflation expectations in Israel. The yield gap between Israeli unindexed 10-year government bonds and US 10-year Treasury notes widened during the period surveyed, and at the end of the period stood at 235 b.p. Short-term makam yields increased by 5–15 b.p. while longer term yields remained stable. New corporate bond issues totaled a gross NIS 2.5 billion in May, and totaled NIS 18 billion for the year to date, compared with NIS 13 billion in the corresponding period of 2010. The Tel-Bond indices of CPI-indexed bonds continued their downward trend of this year, with the Tel-Bond 40 falling by 0.6 percent. Israel's sovereign risk premium as measured by the five-year CDS spread remained almost unchanged over the month, at 144 b.p.
The money supply: In the twelve months ending in May the M1 monetary aggregate (cash held by the public and demand deposits) increased by 4.5 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 8.5 percent.
Developments in the market for housing credit: The balance of outstanding credit to the business sector increased in April by 0.5 percent, to NIS 771 billion. Outstanding credit to households increased by 0.3 percent in April, to NIS 347 billion. Housing credit rose 14.1 percent in the twelve months ending in April, to NIS 243 billion. In March, the increase over the past twelve months was 13.2 percent. The share of new mortgages that were not indexed to the CPI, at variable interest rates, continued to fall, reaching 43.3 percent in May, down from 47 percent in April. On May 5, 2011, a Bank of Israel directive regarding the maximum permitted share of a housing loan at a floating interest rate went into effect. The effect of the directive is not yet fully seen in May mortgage figures, since some of those mortgages were signed before the directive was given. Interest rates on mortgages of all types increased in May.
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 March–April they increased at a rate of 1.5 percent a month, following their increase of 0.8 percent a month in February–March. The annual pace of rises in house prices continues to be high. In the twelve months ended in May, house prices increased by 15.3 percent; up from 13.9 percent in the twelve months ended in April. The housing price index, which is based mainly on renewed rental contracts and which is included in the CPI continued to increase, rising 1.1 percent in May. In the last twelve months it has increased by 6.4 percent. In May, the Ministry of Finance decided to abolish the betterment tax on the sale of a second (or additional) home as of the beginning of 2013. This step is expected to slow the rise of house prices in the coming year.
The global economy: Most macroeconomic figures published this month continued to point to a slowing in the pace of the global economic recovery. Most of the weakness is focused in the US, Europe (excluding Germany), and several East Asian economies. As a result, investment houses revised downward their forecast of world economic growth. With that, the OECD and IMF emphasize that recent weakness is temporary, and the central scenario in the forecasts of both those institutions is for a slight acceleration in growth. The debt crisis in Europe worsened, primarily against the background of the crisis in Greece. Nonetheless, in recent days, international institutions have authorized the plan proposed by Greece's government. This clears the way for additional aid to that country. Despite that, the risk of a banking debt crisis in Europe increased significantly. Commodity prices continue to stabilize and even fall, though despite that, inflation figures in several important economies continue to surprise on the high side, and pose a significant challenge to central banks. The central banks need to deal with weakness in real economic activity, while at the same time dealing with inflation. Against the background of the state of real economic activity and inflation, the widely held estimates are that central banks around the world will continue to raise interest rates, but at a more moderate pace.
The main considerations behind the decision
The decision to leave the interest rate for July at 3.25 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 further growth, 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, economic 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 over the previous twelve months continues to be high, at 4.1 percent. However, inflation expectations for the next twelve months derived from the capital market and the average of the forecasters’ expectations declined over the past month, and are now slightly below the upper limit of the range. The past three CPI readings have been consistent with achieving the target inflation range.
  Economic indicators published this month point to continued expansion of economic activity and expectations are that the expansion will continue in the second quarter, even if at a more moderate pace. With that, there is growing concern over slower US economic growth and the worsening risks of debt problems in Europe and their implications for Israel's economy.
  The annual rate of increase in house prices continues to be high––in the last twelve months house prices increased by 15.3 percent. With that, the effect of interest rate increases, steps by the Bank of Israel in the mortgage market, and steps by the Ministry of Finance regarding real estate taxation, together with the continued growth in building starts, are expected to affect housing prices over the course of the coming year.
  Central bank interest rates in the major advanced economies are still low, and are expected to remain so in the next few months. Against the background of the acceleration in inflation in fast growing economies, several central banks increased their interest rates again this month. However, the concern of a slowdown in US growth and the worsening of debt risks in Europe led to expectations of a slowdown in the pace of interest rate increases in other markets.
In the first half of the year the Bank of Israel raised the interest rate markedly. At the same time, steps were taken by the Bank of Israel and the Ministry of Finance in the housing market. In addition, the shekel appreciated over recent months and there was a decline in commodity prices. The impact on inflation of these items is expected to be felt in the future. In light of these issues, and the marked increase of risks in the global economy, it was decided to leave the interest rate at its current level at this time.
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 July 11, 2011.
The decision regarding the interest rate for August 2011 will be published at 17:30 on Monday, July 25, 2011.