Monetary Policy Report for January-June 2011

Letter of the Governor accompanying the Monetary Policy Report for January–June 2011
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The Monetary Policy Report for the first half of 2011 (the period reviewed in this report) is submitted to the government, the Knesset, and the public as part of the process of assessing the inflation rate in relation to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.[1]
The Consumer Price Index (CPI) increased by 2.2 percent over the course of the first half of 2011. Contributing to the large increase (an annualized rate of 4.4 percent) was an increase of 3.5 percent in the housing component (representing rentals), as well as the food (4.4 percent) and energy (6.6 percent) components. The rise in prices during the period reviewed was affected by domestic factors, primarily housing, as well as by external factors—commodity and energy prices. In each month of the period reviewed, the price increase over the previous 12 months exceeded 3 percent—the upper limit of the 1–3 percent inflation target range. However, monthly figures (seasonally adjusted) show that in the last four months there has been a drop in the rate of price increases, compared with the months preceeding them.
The global recovery from the crisis of 2008 continues, with advanced economies growing slowly and emerging economies growing rapidly. According to an International Monetary Fund (IMF) forecast for 2011, advanced economies are expected to grow by 2.2 percent and emerging and developing economies are seen growing by 6.6 percent. In the period surveyed, commodity and crude oil prices rose, raising with them inflation forecasts for 2011 to 2.6 percent in advanced economies and 6.9 percent in emerging economies. With regard to interest rates, increases are not expected in the US in the coming year. In the eurozone, the European Central Bank (ECB) raised the interest rate for April and July by 0.25 percentage points each time, but there has been growing uncertainty there recently regarding the rate of growth and the future interest rate path; this stems from the increasing concerns over the debt crisis in several European countries which could also have an impact on global financial stability. The expanding national debt in most advanced economies and the high rate of inflation in emerging economies are expected to lead to policies of fiscal restraint (in advanced economies) and monetary tightening (in emerging economies), which may slow global growth. One of the expressions of these expectations is, apparently, a drop in prices of financial assets around the world in the period surveyed.
In the Israeli economy, the recovery in real economic activity and decline in unemployment continued in the first quarter of 2011. Growth was based on an increase in investment, as well as in exports, which were influenced by expanding global trade. Indicators for the second quarter point to a continued expansion of business activity, albeit at a slower pace than the first quarter.
In the period surveyed, prices of financial assets—mainly stocks and corporate bonds—fell, in line with similar developments of equity prices around the world. Nonetheless, house prices continued to rise in Israel—by 3.8 percent during the first four months of the year, and by 13.7 percent between April-May 2010 and April-May 2011. In light of the continued increase in the volume of variable rate mortgages, and in order to prevent the possibility of decline in the stability of banks, as of May 2011 the Bank of Israel limited the variable rate component to one third of each mortgage. A reporting requirement was also imposed on the banks, obliging them to advise borrowers who had already taken out housing loans at variable rates as to the effects of an increase in interest rates on their monthly payments.
In January, there was a marked depreciation of the shekel, apparently as a result of the growing instability in various Middle East countries, and as a result of steps taken by the Bank of Israel and the Ministry of Finance (see below). Later in the period surveyed, the appreciation of the effective exchange rate of the shekel resumed, due in part to the interest rate gap vis-?-vis the US and the eurozone. Overall, the shekel appreciated 0.8 percent during the period. In order to moderate the appreciation of the shekel, the Bank of Israel continued to buy foreign currency. At the same time, in order to moderate speculative short-term capital movements and increase financial stability, at the end of January, the Bank of Israel imposed on banking corporations a reserve requirement of 10 percent against nonresident transactions in foreign currency derivatives. The Bank of Israel also reported the imposing of a reporting requirement on transactions in foreign currency derivatives, and a reporting requirement on nonresident transactions in makam and short-term government debt, which came into effect at the beginning of July; this in order to track the entrance of capital into the economy. At the same time, the Ministry of Finance canceled nonresident investors' capital gains tax exemption in investments in makam and short term government notes, in order to moderate speculative capital flows.
During the period surveyed, the Bank of Israel accelerated the pace of interest rate hikes. The interest rate both for February and for March was raised 0.25 percentage points, the interest rate for April was raised 0.5 percentage points, and the interest rate for June was raised 0.25 percentage points, for a cumulative rise of 1.25 percentage points during the period, to a level of 3.25 percent in June. The reasons for the increases were the rate of inflation, measured over the previous twelve month period, which throughout the period was above the upper limit of the target range, the relatively high level of inflation expectations (for the next twelve months), both by forecasters and as derived from the capital market, as well as the continued economic growth, and the continued rapid rise in house prices. At the same time, the Bank of Israel continued to operate in the foreign currency market in order to moderate the appreciation pressures on the shekel. Toward the end of the period surveyed, the possibility of some slowdown in economic activity developed, and economic and financial uncertainty increased greatly, primarily in light of global developments and the regional geopolitical situation. Signs were also seen of a possible moderation in the rate of inflation. Against this background, the Bank of Israel kept the interest rate for July and August unchanged
The Bank of Israel Research Department forecasts that Israel's economy will grow 4.8 percent in 2011 and that the unemployment rate will fall to an average for the year of slightly below 6 percent (down from 6.6 percent in 2010). Inflation, as measured by the change in the CPI, over the next four quarters (beginning in the third quarter of 2011) is expected to decline to 2.9 percent, and over the course of the second half of 2012 to remain within the target range. The Research Department estimates that the Bank of Israel interest rate will rise gradually to a level of 3.9 percent in the second quarter of 2012. According to the forecast, the key contributing factors to the increases in prices, and the increase in the interest rate, during the coming year are expected to be a continued rise in rents and the high level of prices of commodities and energy, which are expected to remain in place over the course of the year.
The Bank of Israel will continue to follow developments in Israel and worldwide, and to conduct policies which support growth and financial stability, at the same time as striving to return inflation to within the target range (expected, according to the Research Department staff forecast, during the course of 2012). The extent and timing of interest rate adjustments will be set according to inflation developments, the sustainability of growth in Israel and abroad, and developments in the exchange rate of the shekel, in asset prices, and in interest rates by leading central banks.
[1] Previously the Inflation Report. The name is changed to accord with the term in the new Bank of Israel Law that calls for a Periodic Report on Monetary Policy to be submitted by the Monetary Committee not less than twice annually. When the Monetary Committee is appointed, in accordance with the new Bank of Israel Law (5770-2010), interest rate decisions will be made by the Committee, and it will present the Monetary Policy Report.