The Bank of Israel reduces the interest rate for December 2011 by 0.25 percentage points to 2.75 percent

28.11.2011
 
The Bank of Israel reduces the interest rate for December 2011 by 0.25 percentage points to 2.75 percent
 
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Background conditions
Inflation data: The Consumer Price Index (CPI) increased 0.1 percent in October, in line with forecasts, and within the seasonal path consistent with achieving the inflation target. The rate of inflation over the past 12 months, as measured by the change in the CPI, continued to settle more firmly within the target range (1–3 percent per year) and is now 2.7 percent.
Inflation and interest rate forecasts: Inflation expectations, as calculated from the capital markets, remained at the same level as in the previous month at around 1.7 percent. With that, after publication of the October CPI, expectations rose slightly to 1.9 percent. Expectations for the medium and longer terms also remained steady at an average of 2.3 percent. Forecasters' inflation predictions for the next twelve CPI readings were 2.3 percent on average, compared with 2.2 percent last month. Expectations of the Bank of Israel interest rate one year from now, based on the Telbor (Tel Aviv Inter-Bank Offered Rate) market, remained at 2.7 percent, while the average of forecasters' predictions of the interest rate in one year's time continued to decline, and reached 2.75 percent (compared with 3 percent last month). Most forecasters expect the Bank of Israel to cut the interest rate for December by 0.25 percentage points, and on average they expect the interest rate to be reduced by 0.38 percentage points over the next three months.
Real economic activity: Economic indicators that became available this month support the assessment that in the third quarter and in October the slowdown in the rate of growth of economic activity and of demand continued. With that, these figures are currently consistent with the Bank of Israel forecast of 4.7 percent growth in 2011. According to National Accounts figures for the third quarter (in annual terms), GDP grew 3.4 percent, similar to its growth rate in the previous quarter; business product grew 5.3 percent, compared with 2.7 percent in the previous quarter; private consumption increased by 0.9 percent, compared with 1.3 percent in the previous quarter, gross fixed capital formation increased by 17.8 percent, compared with 9.3 percent in the previous quarter; and exports declined 16.9 percent, compared with growth of 1.5 percent in the previous quarter. The Composite State of the Economy Index increased slightly in October, by 0.1 percent. The Bank of Israel's Companies Survey and the new Central Bureau of Statistics survey of business trends showed that the slowdown in private sector business activity persisted and even intensified in October. In contrast, the Bank Hapoalim consumer confidence index increased in October, to a level of 50.7, the first time in three months that the figure has been above the 50 point level. Tax receipts in October were 8 percent lower than the forecast seasonal path, a continuation of the slowdown that began in April.
The labor market and wages: Labor market data indicate a high level of employment and a low unemployment rate. Based on trend data, the rate of unemployment declined by 0.1 percentage points in August, and reached 5.6 percent. The number of Israeli employee posts increased by 3.1 percent in June–August, in annual terms, compared with the corresponding period of 2010. The nominal wage rose in June–August by 0.3 percent, compared with the preceding three months, and the real wage increased 0.15 percent in June–August, compared with the preceding three months. Health tax receipts, which provide an indication of wage payments, were 8 percent higher in October (preliminary estimate) in nominal terms than in October 2010 (excluding the effect of legislative changes).
The Bank of Israel Research Department staff forecast: According to the Research Department staff forecast (from September), the rate of inflation over the four quarters ending in the third quarter of 2012 will be 2.3 percent, and the average interest rate in 2012 is expected to be 3 percent. The GDP growth forecast is 4.7 percent for 2011, and 3.2 percent for 2012. The assessment is based on, among other things, a lowered International Monetary Fund (IMF) forecast of global growth and world trade. Last month the Research Department examined the possible effect on Israel's economy of a scenario in which global growth is 1 percentage point lower than the base scenario. If the lower growth scenario is realized, GDP growth in Israel is forecast to be about 0.5 percentage points lower in 2012 than in the base scenario. Inflation over the four quarters ending in the third quarter of 2012 is forecast to be 0.8 percentage points lower than in the base scenario, and the average interest rate for 2012 is expected to be 1 percentage point lower than in the base scenario.
Budget data: Government domestic revenues for the year to date through October were 2.7 percent lower than the seasonal path of the budget forecast, primarily due to a continued slowdown in indirect tax receipts, which began in April. The overall government deficit (excluding net credit) in the year to date was NIS 14 billion, compared to a deficit of NIS 16.3 billion in the corresponding period in 2010. Developments in government activity so far indicate that tax revenues will be about 2 percent lower than the budget forecast, and the budget deficit for the year 2011 will be around 0.5 percent of GDP above the deficit ceiling set by law—3 percent of GDP.
The foreign exchange market: From the previous monetary policy discussion held on October 23, through November 25, the shekel depreciated by about 3.8 percent against the dollar, in line with the general strengthening of the dollar world wide. The shekel was essentially unchanged against the euro (appreciation of 0.1 percent). The shekel weakened by about 2 percent in terms of the nominal effective exchange rate. The rate of participation by nonresident investors in foreign currency trading was 30 percent in November, compared with the average of 35 percent since the beginning of 2011.
The capital and money markets: From the previous monetary policy discussion held on October 23, through November 25, the Tel Aviv 25 Index declined by 8.3 percent, more than stock market indices in advanced economies unconnected with the debt crisis. The unindexed government bond market responded with declining rates for most maturities of up to 10 basis points (b.p.), while the yield curve of CPI-indexed government bonds declined sharply in short maturities, and increased by up to 15 b.p. for terms to maturity of over 4 years. The yield gap between Israeli 10-year government bonds and equivalent 10-year US Treasury securities widened to about 270 b.p., from 250 b.p. in the previous month. Makam yields increased slightly for maturities of up to 8 months, and declined slightly in longer terms. The yield for one year fell during the period from 2.8 percent to 2.7 percent—against the background of an exit from risk assets and expectations of continued interest rate cuts by the Bank of Israel, and despite the continued exit of nonresidents from makam. Withdrawals from mutual funds specializing in corporate bonds continued this month, although at a slower pace than that in the previous month. Israel's sovereign risk premium as measured by the five-year CDS spread increased this month to 215 basis points from last month's 160 basis points. The Tel-Bond 20 Index declined by 1.4 percent, and the Tel-Bond 40 Index declined by 2.1 percent.
The money supply: In the twelve months ending in October, the M1 monetary aggregate (cash held by the public and demand deposits) increased by 2 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 14.1 percent.
Developments in the credit markets: The balance of outstanding debt of the business sector increased in September by 1.7 percent, to NIS 781 billion. Outstanding credit to households remained at NIS 359 billion in September, with an increase of 0.8 percent in outstanding housing credit, and a decrease of 1.8 percent in non-housing credit. Of the credit to households, outstanding housing credit rose 11.3 percent in the twelve months ending in September to NIS 257 billion, compared with a 10.9 percent increase in the twelve months to August. The volume of new housing credit granted in the twelve months ending in October was 2.2 percent lower than in the twelve months ending in September—a continuation of consecutive declines since the record high set in May. The share of unindexed floating rate mortgages extended in October was 26.6 percent, after reaching 26.1 percent in August. These percentages are significantly lower than the record levels of the first quarter of 2009—about 75 percent on average. The interest rates on CPI-indexed mortgages—both fixed rate and variable rate—increased in October, while interest rates on variable rate unindexed mortgages declined.
The housing market: Activity in the construction industry continues to be strong. The number of starts in the twelve months to August reached 43,672, and the number of completions was 33,605, both similar to the numbers in the previous month. The number of homes available for sale continued to increase, and in August–October was on average 8.3 percent higher than in the three preceding months (original data). The Central Bureau of Statistics Survey of Business Trends indicates a decline in activity and in new orders in the industry.
Housing prices reflected in the housing index, which is based mainly on renewed rental contracts and which is included in the CPI, declined 0.3 percent in October, but over the 12 months ending in October they increased by 6.3 percent—compared with an increase of 5.5 percent in the 12 months ending in September—and prices are expected, according to the Research Department forecast, to continue to increase at a similar pace in the coming year. Home prices, which are published in the Central Bureau of Statistics survey of home prices but are not included in the CPI, declined in August–September by 0.2 percent (the first decline since December 2008) after an increase of 0.6 percent in July–August. The annual rate of increase in home prices also moderated—in the 12 months ending in September the rate was 10.5 percent, compared with 12.1 percent in the 12 months ending in August, and this after levels of around 20 percent in 2010.
The moderation in home prices comes against the background of the continued increase in the number of building starts, the lagged effect of 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. The effect of these moves is expected to continue and be evident going forward.
The global economy: The debt crisis in Europe is deepening and spreading to additional countries. There is growing concern of a severe impact on the global economy. Austerity measures announced by several European countries have not succeeded, to date, to calm the markets. Yields on government bonds of Italy, Spain, and other countries in the eurozone have reached high and apparently unsustainable levels. The banking sector around the world, specifically in Europe, is under pressure due to its exposure to bonds of countries in difficulty, and in the event of a crisis would be liable to contribute significantly to the contagion effect, and to lead to the spread of the European crisis to other countries over and above the macroeconomic effects resulting from the contraction of world trade. Last month credit rating companies made further cuts in the rating of European countries, and warned of the credit rating outlook of other countries and of banks around the world. Macroeconomic figures published this month in the US were relatively favorable, and were generally better than expected, but they are still relatively weak. Data published in Europe were weaker, and many forecasters and investment houses expect that Europe will slip into a recession that is likely to deteriorate in light of the austerity measures announced in several countries. Inflation around the world is starting to moderate, and commodity prices that fell sharply are expected to reduce it further, but the increase in oil prices this year, that was out of line with the economic situation and with the fall in industrial metal prices, constitutes a burden on the already weak global economy. Against the background of these developments, the ECB made a surprise cut in the interest rate this month, and the markets are pricing in interest rate cuts in other economies.
The main considerations behind the decision
The decision to reduce the interest rate to 2.75 percent for December is consistent with the interest rate policy that is intended to entrench the inflation rate within the price stability target of 1–3 percent inflation a year over the next twelve months, and to support growth while maintaining financial stability. The path of the interest rate in the future depends on developments in the inflation environment, growth in Israel, the global economy, the monetary policies of major central banks, and developments in the exchange rate of the shekel.
  The debt crisis in Europe is becoming more severe and is spreading to other countries, and there is growing concern over its potentially strong impact on the global economy. Yields on government bonds of Italy, Spain, and other countries in the eurozone have reached high and apparently unsustainable levels. In light of the weak economic data published in Europe, the risk of Europe sliding into a recession and a significant slowdown in the global economy has risen. These negative developments are already affecting the Israeli economy, and their effect is expected to intensify.
  Economic indicators that became available this month support the assessment that in the third quarter and in October the slowdown in the rate of growth of economic activity continued. Most of the slowdown in the domestic economy resulted from the easing in global demand and its effect on exports, and also to some extent from the slackening of domestic demand.
  Inflation forecasts for the next twelve months as calculated from the capital market, those of the forecasters and that of the Bank of Israel are all close to the midpoint of the target inflation range. Actual inflation over the last twelve months is within the target range for the second month in succession, and is expected to remain there over the next year.
  The persistent negative trends in Europe led to a cut in the ECB interest rate and to cuts in interest rates in other countries, and resulted in the markets not pricing in an increase in the interest rate in the coming year in any of the major advanced economies. According to the announcement by the Federal Reserve, the interest rate in the US is expected to remain at its almost zero level till the middle of 2013 at least, and the Fed and the ECB are continuing with their quantitative easing measures.
  Home prices increased by 10.5 percent in the twelve months ending September, compared with 12.1 percent in the twelve months to August. In August–September home prices declined for the first time since December 2008. The continued increase in the number of building starts, the delayed effect of 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 are all expected to continue to moderate home prices during the coming year. It should be noted that the limitation imposed by the Bank of Israel on the share of housing loans at variable interest rate reduces the effect of a cut in the interest rate on the average rate of interest on mortgages.
The reduction in the interest rate, together with the recent weakening of the effective exchange rate of the shekel, are expected to help Israel's economy deal with the difficulties confronting it.
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 tools 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 December 12, 2011.
The decision regarding the interest rate for January 2012 will be published at 17:30 on Monday, December 26, 2011.