The Monetary Policy Report for the second half of 2018

  • Monetary policy: This report reviews the monetary policy in the second half of 2018 and in the beginning of 2019.[1] During the reviewed period, the Monetary Committee began the process of tightening the accommodative monetary policy adopted in recent years. Against the background of the relative stability in the exchange rate, the Bank of Israel did not purchase foreign exchange within the framework of the policy to avoid anomalous exchange rate fluctuations, and sufficed with purchases carried out within the framework of the program to offset the effects of natural gas production. In November, the Monetary Committee announced that the program to offset the effects of natural gas production would cease at the end of 2018. During the course of the reviewed half year, the Committee continued to use the forward guidance tool and in particular reiterated the declaration that the accommodative monetary policy will remain in place as long as necessary to entrench the inflation environment within the target range. In its publications, it clarified this declaration and sharpened the meaning of entrenchment. A significant step in the process of tightening the monetary accommodation was taken in the final interest rate decision for 2018—the Committee decided to increase the interest rate to 0.25 percent, after assessing that the conditions were set for the beginning of the rise; that is, after inflation had stabilized above the lower bound of the target range, and the Committee assessed that it will remain stable and that even at this interest rate, policy is accommodative and supports the objectives. In addition, the Committee reiterated the assessment that the interest rate path in the future would be gradual and cautious. In the decision in January, the Committee also emphasized that the decisions on future interest rate increases will be made in a manner that supports a process at the end of which the inflation rate will stabilize around the midpoint of the target range and that supports economic activity.
  • The inflation environment: During the reviewed period, various indicators pointed to the inflation environment having increased and having become entrenched in the lower part of the target range: with the publication of the CPI reading for June, annual inflation entered the target range, for the first time in about 4 years, and during the course of the half year it remained within it. Most components of the CPI made a positive contribution; the index of nontradable items —an approximation of the domestic component of inflation—renewed its rise and remained at a high level. Annual inflation excluding energy, fruit and vegetables, and excluding the price reductions initiated by the government, ranged around 1 percent. One-year expectations derived from the capital market remained within the target range during the period, and forward expectations were stable within it. Throughout the half year, the Committee was of the opinion that there were various factors acting to increase the inflation environment, including wage increases, fiscal policy, and global developments. It was also of the view that the impact of some of the factors that had reduced the inflation rate in recent years had weakened, including the government-initiated price reductions and the trend of appreciation. The CPI for December was published after the end of the reviewed period, and indicated that the inflation rate in 2018 was 0.8 percent.
  • Real domestic activity: The data published during the reviewed period led the Monetary Committee to assess that activity had moderated to some extent, but they were of the opinion that this apparently derived from the growth rate returning to the potential environment and the fluctuations seen in vehicle imports in the first quarter. Regarding the composition of GDP, National Accounts data published during the half pointed to several developments: continued contraction in investment, a moderate rise in private consumption, and weakness in goods exports. The Committee discussed these developments and assessed that they derive mainly from the limitations created on the supply side due to the proximity to full employment, and not from weakening demand. Labor market data indicated that it remained tight—employment and participation rates remained high, the unemployment rate was at a low, the job vacancy rate remained at a high level, and wages continued to increase at a solid pace, led by the business sector.
  • Capital market developments: Market expectations with regard to an interest rate increase rose in the beginning of the half to a level that reflected more than one increase during the coming year. Forecasters’ assessments and Telbor data indicated that the markets did not expect the increase that took place in November, and their initial reaction to it indicates that they derived from it that other increases will be brought forward as well. Israeli government nominal bond yields increased gradually during 2018. The spreads between Israel and the US in 5-year and 10-year nominal bond yields remained negative and stable in most of the reviewed period, although the most recent data indicate that they narrowed. The spreads between yields on corporate bonds rated A and higher and those on government bonds declined slightly in August, but in the beginning of October there was a correction and in November and December the upward trend continued. In December, equity indices declined on the Tel Aviv Stock Exchange by approximately 10 percent, in line with the marked declines in major equity indices worldwide.
  • v  The housing market: Home prices increased for about a decade, reached a peak in August 2017, and from then until September 2018 they declined by approximately 2 percent.[2] The number of new housing transactions stabilized during the course of the period, after it rose to some extent in the beginning of the year and after it had declined consistently since the middle of 2016. With that, there was a continued upward trend in the number of homes sold within the framework of the “Buyer’s Price” program. During the course of the period, a marked slowdown was apparent in the number of building starts and in residential construction investment. The Monetary Committee assessed that the slowdown in residential construction apparently derived from moderation in demand.
  • Global developments: Data on the global economy indicated a loss of momentum throughout the half year, and the IMF reduced its growth forecast. The US economy continued to grow by a high rate, but it is expected that the pace will moderate slightly in the fourth quarter. In Europe, activity lost momentum. During the period, the Committee saw several risks that in its assessment weigh on the continued trend of global growth, including trade wars, political risk in Europe, and the volatility in emerging economies’ financial markets. The monetary environment worldwide remained accommodative but showed a clear trend of contraction. The US continued its process of normalization and the US Federal Reserve raised the federal funds rate twice. The eurozone kept the monetary interest rate at a negative level, and the ECB repeated the assessment that it will stay at its current level through the summer of 2019, at least. From the beginning of 2019, quantitative easing worldwide is expected to be replaced by quantitative tightening. However, at the end of the reviewed period, uncertainty increased regarding the continued trend of monetary contraction around the world, against the background of financial market volatility in advanced economies. The markets are not pricing in an additional interest rate increase in the US, and in Europe the timing for the interest rate being expected to increase was deferred.
  • Exchange rate: During the half-year reviewed, the nominal effective exchange rate did not develop uniformly: the shekel strengthened until the beginning of September, and afterward it depreciated. Committee members agreed that from a historical perspective, the shekel remains overvalued, but they assessed that the forces for appreciation weakened against the background of the increase in the interest rate spreads between Israel and other countries, and the contraction of the surplus in the current account of the balance of payments. During the course of the half-year, the Bank of Israel did not intervene in the foreign exchange market with the goal of preventing anomalous exchange rate fluctuations, and sufficed with purchases within the framework of the program to offset the effect of natural gas production.[3]
  • Research Department staff forecast: In January 2019, the growth forecast for 2019 was revised downward (to 3.4 percent), among other things against the background of the assessment that growth is converging more rapidly to the long term pace. In 2020, GDP is expected to grow by 3.5 percent. The inflation forecast for 2019 was reduced (to 1.3 percent), among other things because the price of oil declined in the fourth quarter. In 2020, inflation is expected to continue converging gradually to the midpoint of the target range and to be 1.8 percent by the end of the year. The interest rate is expected to increase to 0.5 percent in the third quarter of 2019, and to rise gradually to 1.25 percent at the end of 2020 (the end of the forecast range).



[1] Decisions in 2018 were reached on July 9, August 29, October 8, November 26, and the decision in 2019 was reached on January 7.

[2] This is the updated data that the Committee had in its interest-rate decision in January 2019.

[3] In May, the Bank of Israel intervened in the foreign exchange market but at a very low amount—$13 million.