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

The Bank of Israel leaves the interest rate for September 2011 unchanged at 3.25 percent
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Background conditions
Inflation data: The Consumer Price Index (CPI) declined 0.3 percent in July, below the average forecast and below the seasonal path consistent with achieving the inflation target. On a seasonally adjusted basis, the CPI in July fell 0.6 percent. Inflation over the past 12 months, as measured by the change in the CPI, was 3.4 percent, above the upper limit of the target inflation range (of 1–3 percent a year).
Inflation and interest rate forecasts: Inflation expectations for the next twelve months, both those of forecasters and those calculated from the capital markets, fell significantly over the past month. Inflation expectations for the next twelve months as calculated from the capital market are currently 2 percent, and forecasters' inflation expectations for the next twelve months are currently 2.5 percent. The background to the drop in inflation expectations was a fall in commodity prices, the surprisingly low July CPI reading, expectations of a slowdown in growth, and the social protests against the high cost of living. At the same time, forecasts, both of forecasters and those calculated from the capital markets, of the Bank of Israel interest rate fell. 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 3.1 percent, down from 4 percent a month ago, and the average of forecasters' predictions is that it will be 3.6 percent (down from 4.3 percent a month ago). Forecasters expect the Bank of Israel to leave the interest rate for September unchanged.
Real economic activity: Economic indicators that became available this month continue to support the assessment that the economy continues to expand, albeit more slowly than in previous quarters. The slowdown in the rate of growth stems mainly from moderation in global demand, which influences goods exports by manufacturers, as well as services exports. At the same time, domestic demand continues to grow. Based on National Accounts data for the second quarter (in annualized terms), GDP grew 3.3 percent and gross domestic product of the business sector grew 1.9 percent. With that, these figures are essentially consistent with the Bank of Israel forecast of 4.8 percent GDP growth for the full year of 2011. Exports (excluding diamonds) grew 0.5 percent quarter on quarter, in the second quarter, compared with an increase of 10.1 percent in the first quarter. Private consumption increased 2.3 percent, compared with 7.8 percent in the first quarter. However, private consumption, excluding relatively volatile consumer durables, grew 4.6 percent, compared with 4.3 percent in the first quarter. The moderation in the rate of growth was also seen in the composite state-of-the-economy index, which increased by 0.2 percent in July, continuing the relatively modest increases of the second quarter. Tax receipts continue to be below the seasonal path, for the fourth consecutive month. However, expectations for future activity, based on the Central Bureau of Statistics survey of business trends as well as the "Globes" and the "Bank Hapoalim" consumer confidence indices, are positive.
The labor market and wages: Labor market data indicate a continued improvement in employment. The trend figure for May shows a 5.7 percent unemployment rate in the civilian workforce. The number of employee posts (seasonally adjusted) increased by 0.6 percent in March–May compared with the previous three months. The Central Bureau of Statistics job vacancy survey shows that the number of job vacancies increased by 2.2 percent in July. The nominal wage increased in March–May by 1.4 percent compared with the level in the previous three months, while the real wage (seasonally adjusted) was stable. In July, health tax receipts, which provide an indication of wage payments in that month, were 6.8 percent higher (preliminary estimate), in nominal terms, than in July 2010 (excluding the effect of legislative changes).
The Bank of Israel Research Department staff forecast: Following a deterioration in the global economic environment in the past month, the Research Department's staff forecast is somewhat changed compared with last month. The current assessment is that inflation in the 12 months ending in the third quarter of 2012 will be 2.5 percent, and the average interest rate for that quarter will be 3.3 percent. For the full year of 2011, the Research Department forecasts that the inflation rate will be 2.7 percent, and that the average interest rate in the fourth quarter will be 3.3 percent. The Research Department emphasized the primary risks faced by Israel's economy, specifically, the realization of the pessimistic assessments regarding developments in the global economy and their expected impact on demand for Israel's exports and on domestic demand, and negative geopolitical developments.
Budget data: Government domestic revenues in July were 3.5 percent lower than the forecast seasonal path, continuing a slowdown in indirect tax revenues. At the same time, tax revenues for the year to date, through July, were 5.7 percent higher, in real terms, than in the corresponding period of the year before, and NIS 100 million above the seasonal path of the budget forecast (net of legislative changes and one time revenues). The government's domestic activity in the first seven months of this year (excluding credit) resulted in a cumulative deficit of 0.4 percent of GDP, compared with a deficit of 1.2 percent of GDP in the corresponding period of 2010. Developments in government activity so far indicate that the budget deficit for the full year of 2011 will be between 2.7 percent and 3 percent of GDP. (The deficit ceiling set by law is 3 percent.)
The foreign exchange market: From the previous monetary policy discussion held on July 24, through August 26, the shekel depreciated by about 7 percent against both the dollar and the euro, and weakened by about 6.6 percent vis-?-vis the nominal effective exchange rate. This is a considerably greater depreciation than that of the main currencies against the dollar. This was apparently against the background of a change in market expectations of the path of the Bank of Israel interest rate, which, in contrast to expectations in recent months, now do not forecast an increase in the interest rate in the coming period. It is possible as well that the deterioration of the security situation in the south of Israel and other geopolitical risks led to weakening of the shekel.
The capital and money markets: Between the monetary policy discussions of July 24 and August 26, Tel Aviv Stock Exchange share price indices fell sharply, in line with the general trend in stock markets around the world. The Tel Aviv 25 Index fell by 14 percent, a move similar to that of US stock market indices. Yields on local currency government bonds declined sharply by 25–65 basis points (b.p.) across the entire yield curve, most markedly in the short end of the curve. The yield curve on CPI-indexed government bonds flattened, with a sharp rise of up to 35 basis points in short terms and a drop of 5–12 basis points in the medium to long terms. This was against the background of a sharp drop in inflation expectations for the next two years, from about 3 percent per year last month to 2 percent per year currently. The yield gap between Israeli unindexed 10-year government notes and 10-year US Treasury notes widened considerably during the period surveyed, and at the end of the period stood at 266 b.p. (up from 214 b.p. at the beginning of the period). Makam yields fell by up to 40 b.p., across the curve, as the yield for one year fell during the period from 3.5 percent to 3.08 percent. Withdrawals from mutual funds specializing in corporate bonds continue. In the last three months, about NIS 10 billion were withdrawn. In contrast, money market funds continue to attract new investment, and in the past three months about NIS 10.8 billion flowed into those funds. This pace is considerably faster than that seen in the period before the Lehman Brothers crisis. The negative sentiment in the corporate bond market can be seen as well in the widening yield spread against government bonds. The yield spread between the Tel-Bond 40 and government bonds widened from 200 b.p. to 288 basis points since the last monetary policy discussion. Over the period as a whole, Israel's sovereign risk premium as measured by the five-year CDS spread rose by 28 basis points, and at the end of the period was 166 b.p.
The money supply: In the twelve months ending in July the M1 monetary aggregate (cash held by the public and demand deposits) increased by 3.2 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 9.3 percent.
Developments in the credit markets: The balance of outstanding credit to the business sector decreased in June by 0.7 percent, to NIS 748 billion. Outstanding credit to households increased by 0.9 percent in June, to NIS 354 billion. Of the credit to households, outstanding housing credit rose 12.3 percent in the twelve months ending in June, to NIS 252 billion, compared with a 13.9 percent increase in the twelve months to May. The volume of new housing credit granted in the twelve months ending in July was 1.4 percent lower than the previous month (twelve months to June). The share of mortgages at floating interest rates (for all maturities) in total new mortgages continued to decline in July, and reached 79 percent, compared with 81 percent in June; Following a Bank of Israel directive that went into effect on May 5, 2011, the share of mortgages at interest rates that vary once in five years or less is expected to continue to fall. The interest rates on CPI-indexed and unindexed floating rate mortgages continued to increase in July, while the interest rates on fixed-interest rate CPI-indexed mortgages declined.
The housing market: Data on building starts and completions show that activity in the construction industry continues to gain strength. The upward trend in starts and completions that started at the beginning of 2008 persists. The number of starts in the twelve months to May reached 42,304, compared with 41,138 in the twelve months to April, and the number of completions was 33,821 twelve months to May, compared with the April figure of 34,095. In comparison, the number of homes sold fell, and in April–June was 7 percent lower than in January–March. The number of homes available for sale continued to increase, and in April–June was on average 5.4 percent higher than the January–March average. Home prices, which are presented in the Central Bureau of Statistics survey of home prices but are not included in the CPI, increased at a monthly rate of 0.7 percent in May–June, after rising at a similar pace in April–May. The annual rate of increase in home prices continues to be high, but declined slightly for the second consecutive month, and in the twelve months ended in June house prices increased by 12.5 percent; compared with a 13.9 percent increase in the May figure. The slowdown in the rate of increase in home prices was influenced by the increase in the interest rate, measures introduced by the Bank of Israel affecting mortgages, and steps taken by the Ministry of Finance in real estate taxation, together with the continued increase in the number of building starts, and these factors are expected to moderate home price increases in the course of the coming year. The housing index, which is based mainly on renewed rental contracts and which is included in the CPI, continued to increase, rising by 0.4 percent in June, bringing the increase in the last twelve months to 5.6 percent.
The global economy: Concern regarding global growth increased this month, in light of the disappointing growth data in the advanced economies. The figures published in the US during the month showed a continued slowdown in growth, and in the second quarter the rate (in annual terms) was only 1 percent, significantly lower than expected rate of 1.8 percent, and the figure for the first quarter was adjusted sharply downwards, from 1.9 percent to only 0.4 percent. The GDP of the eurozone grew at a rate of 0.2 percent in the second quarter, compared with the expectation of 0.3 percent. The average growth in the eurozone was reduced by the zero growth rates in Germany and France, showing a considerable weakening following their respective stronger growth rates of 1.3 percent and 0.9 percent in the first quarter. Concern over global growth intensified also due to the assessment that the set of tools available for economic policy was limited, relative to that in 2008. The emerging market economies are still showing strong growth, but it is expected that this will also slow in the near future due to the slowdown in the advanced economies. In light of this assessment, the investment houses reduced considerably their global growth forecasts for the next two years. Following the lowering of credit ratings of some eurozone countries, S&P this month announced a cut in the US credit rating, which led to severe reactions in the markets around the world. Moody's lowered Japan's credit rating, and there was concern that France's rating may also be lowered. The European debt crisis is still spreading, and presents a threat to Italy and Spain. Inflation expectations fell steeply this month, in light of the expected slowdown in economic activity and the fall in commodity prices. Currently the markets do not expect an increase in interest rates by any of the central banks of the large advanced economies, and the Federal Reserve announced that it would leave the interest rate at its near zero level until mid-2013 at least.
The main considerations behind the decision
The decision to leave the interest rate for September at 3.25 percent is consistent with the process of returning the inflation rate to within the target price-stability range of 1–3 percent a year within the next twelve months, and with supporting economic growth while maintaining financial stability. The future direction of changes in the interest rate will be dependent on the inflation environment, economic growth in Israel and abroad, the monetary policy of the leading central banks, and developments in the exchange rates of the shekel.
  Inflation expectations––those derived from the capital market and predictions of the forecasters––declined significantly last month and are currently 2 percent and 2.5 percent respectively. The current forecast of the Bank of Israel Research Department is that inflation will enter the target range towards the end of 2011, as opposed to the middle of 2012 in the previous forecast. The July CPI was surprisingly low, following four months when the seasonally adjusted CPI inflation rates were in line with the target inflation range. Nevertheless, inflation over the previous twelve months, 3.4 percent, is still above the target range.
  The rate of growth in the second quarter was slower than in the first, mainly due to the slackening of global demand and its effect on exports, whereas domestic demand continued to increase. Developments since the previous interest rate decision indicating a negative turnaround in economic activity in the US and the eurozone, together with the geopolitical risks, are likely to affect economic activity in Israel. Notwithstanding, the relatively good present state of the Israeli economy will enable it to withstand these shocks with a relatively moderate impact.
  The rate of increase in home prices over the last twelve months continues to be high, but moderated for the second month in succession, and in June reached 12.5 percent. With that, the interest rate increases, measures taken by the Bank of Israel in the mortgage market, and measures taken by the Ministry of Finance regarding real estate taxation, together with the continued increase in building starts, are expected to continue and to have a moderating effect on house prices during the coming year.
  As a result of the reversal in the US and Europe, the markets are not pricing in an increase in the interest rate during the coming year by any of the central banks of the main advanced economies. The Federal Reserve announced this month that it would leave its interest rate at its near zero level until mid-2013 at least.
  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 September 12, 2011.
The decision regarding the interest rate for October 2011 will be published at 17:30 on Monday, September 26, 2011.