MONETARY POLICY REPORT-2015 First Half

03/08/2015
All Press Releases In Subject:
Monetary Policy and Inflation

January–June 2015
 Summary
·         Monetary policy: The Bank of Israel’s Monetary Committee reduced the interest rate for March 2015 by 0.15 percentage points, bringing it to a historic record low of 0.10 percent. Financial market expectations had not reflected this reduction, and thus markets responded quite sharply. As the interest rate is near zero, the Committee considered alternative policy tools in the reviewed period. The Bank of Israel also continued to purchase foreign currency—$4.6 billion in the reviewed period—most of which ($3 billion) was purchased within the framework of the plan to moderate extreme foreign exchange rate fluctuations, while the remaining purchases were made under a plan designed to offset the effects of natural gas production on the exchange rate. The Committee maintained the interest rate at this low level of 0.1 percent in July and August, subsequent to the reviewed period.
 
·         Macroprudential policyCommittee members were of the opinion that the primary financial risk stems from credit to the housing sector, and that the steps taken by the Supervisor of Banks in recent years have alleviated those risks.
 
·         Inflation and inflation expectations: In the 12 months ended in June, the Consumer Price Index declined by 0.4 percent, resulting in an inflation rate that was markedly below the lower bound (1.0 percent) of the inflation target range. The inflation rate, as measured by the change in the CPI over the preceding 12 months, was negative over the entire reviewed period, although the month-by-month development of the CPI shows variation across this period: In January and February, the CPI declined sharply, reflecting mainly one-off and anticipated reductions in water and electricity rates, as well as the declines in oil prices over the preceding six month period. There was a turnaround in March, when prices rose once again, in line with the seasonal path consistent with achieving the inflation target. As a result, the pace of decline in the CPI, measured over the preceding 12 months, moderated. Based on various sources, 12-month inflation expectations declined  at the beginning of the period to below the lower bound of the inflation target range, and returned to around the lower bound at the end of the period. Medium to long term inflation expectations remained anchored near the midpoint of the inflation target range throughout the entire period.
 
·         Domestic real economic activity: Data for the six month period that includes the fourth quarter of 2014 and the first quarter of 2015 indicate that the economy returned to the moderate rate of growth that had characterized it prior to Operation Protective Edge. More specifically, data for the fourth quarter of 2014 indicate accelerated activity—an increase of 6.5 percent—which reflected a correction to the previous quarter’s slowdown triggered by Operation Protective Edge. In the first quarter of 2015, the economy continued to grow, albeit at a more moderate pace. In this period growth was driven by private consumption, while it was moderated by a relative standstill in exports amid a renewed trend of appreciation in the shekel and weakness in world trade.
 
·         The labor market: Data for the fourth quarter of 2014 and the first quarter of 2015 indicate a correction, similar to the one in real domestic economic activity: the unemployment rate declined once again, this time to a low of 5.4 percent, after having reached 6.2 percent in the third quarter of 2014. At the same time, the labor force participation rate and the employment rate were stable at an elevated level, while the share of employed people and the job vacancy rate increased. Real wages rose, as did the number of employee posts, with the expansion in public services compensating for contraction in the business sector.
 
·         The exchange rate: In the reviewed period, there was a turnaround in the shekel in terms of the effective exchange rate. After a sharp depreciation in the preceding six month period, the shekel strengthened in terms of the nominal effective exchange rate and against the euro, and to a lesser extent against the dollar as well, during the period reviewed. The background to the shekel’s appreciation in effective exchange rate terms was the ECB’s launch of a quantitative easing asset purchase program, announced in January. As a result of these steps, the euro weakened sharply against major currencies, and, as noted, against the shekel, which led central banks around the world to weaken local currencies. The interest rate reduction for March and foreign exchange purchases over the period partially damped the effective appreciation of the shekel although, according to several estimates, the effective exchange rate of the shekel at the end of the reviewed period is overvalued relative to the equilibrium exchange rate. 
 
·         The global environment: The global economy continues to grow at a moderate rate, although with great variability between countries. At the same time, world trade slowed. Among advanced economies, the US economy continued to grow at a moderate pace despite the contraction in the first quarter of 2015, which apparently stemmed from transitory effects. The European economy showed signs of an improvement in growth although it was still affected by the looming Greek crisis. In developing economies, actual and projected growth rates were lower than in the past. Accommodative monetary policy measures were adopted by central banks worldwide, led by the ECB, which announced a large-scale expanded asset purchase program in response to deflation concerns in the eurozone. US Federal Reserve officials and leading market players anticipate an initial increase in the Fed funds rate toward the end of the year, in September or December 2015.
 
·         The housing market: Home prices and activity levels in the housing market recovered after a virtual standstill in the market during the period of deliberations over the Zero VAT law. The annual rate of increase in home prices (through April-May) did moderate, to 3.2 percent from 4.3 percent in 2014, but prices increased at an annual rate of 6 percent since the beginning of the year (January–April). At the same time, the number of transactions rose markedly in the reviewed period, especially involving homes that would presumably be subject to the anticipated Zero VAT law. Total new mortgages granted in the period also increased, after holding stable in the preceding six month period.
 
·         Financial markets: Key stock market indices (Tel Aviv 25 and Tel Aviv 100) increased in the reviewed period, in line with, but stronger, than the global trend. The economy’s risk level, reflected in the CDS premium on five-year external debt, continued to decline, a trend which has been characteristic of recent years. Total credit to the nonfinancial business sector increased since the beginning of the year, primarily due to the increase in credit from banks and other financial organizations. Corporate bond yield spreads remained low. Outstanding credit to households continued to grow at a pace in line with recent years.
 
·         Fiscal policy: The government’s domestic deficit (excluding net credit granted) in January to June totaled NIS 0.6 billion, about NIS 1.7 billion less than the seasonal path consistent with achieving the target full year debt to GDP ratio of 2.5 percent. The new government’s budget approval process is only set to be concluded toward the end of 2015, and the government has been operating since the beginning of the year under a law that allows it to spend 1/12 of the full-year 2014 budget each month (an interim budget). The deficit for 2015 is expected to be 2.5–2.8 percent of the GDP, near the statutory deficit ceiling.
 
·         Research Department staff forecast of June 2015: According to the forecast compiled by the Research Department in late June 2015, inflation in the next four quarters is expected to increase to 1.6 percent, near the midpoint of the target range. This forecast was influenced by, among other things, an increase in transfer payments, in the minimum wage, and in the growth rate. Nonetheless, there are downside risks to the inflation rate forecast from the renewed decline in oil prices and the continued appreciation of the shekel. GDP is expected to increase by 3.0 percent in 2015, and the pace of GDP growth is expected to improve to 3.7 percent in 2016. This forecast is slighter higher than the previous forecast, which was presented to the Committee in March, for several reasons, including the significant anticipated increase in public consumption and the upward revision in OECD import forecasts, which should improve Israel’s exports. In line with these forecasts, and presuming that liftoff of the Fed funds rate will occur in 2015, the Research Department projected in June that the Monetary Committee will keep the interest rate at the 0.1 percent level throughout 2015 and increase it to 1.25 percent by the end of 2016. The Committee nonetheless felt that the uncertainty surrounding the inflation forecast is biased to the downside, mainly because oil prices continue to decline and in light of the continued shekel appreciation in terms of the effective exchange rate.