The Monetary Policy Report for the first half of 2020

Monetary policy: This report reviews monetary policy during the first half of 2020 and the beginning of the second half of the year.[1] During the reviewed period, against the background of the major deterioration in economic conditions as a result of the spread of the coronavirus and the measures taken to halt it, the Monetary Committee put into operation a range of tools in order to help deal with the crisis. The main measures taken were intended to ensure the orderly functioning of the financial markets, to enhance the passthrough from the Bank of Israel interest rate to the market interest rates and to ease credit conditions.

Among other things, the Committee implemented a program to purchase government and corporate bonds in the secondary market, and a program for repo transactions with institutional investors, and it also began to execute swap transaction in the foreign exchange market, in addition to the purchase of foreign exchange that it carries out from time to time. In addition, the Committee introduced a new monetary instrument—long-term monetary loans to the banks in order to increase the supply of credit to small businesses. In addition, it reduced the interest rate by 0.15 percentage points to a level of 0.1 percent.

Domestic real activity: During the reviewed period, there was a marked deterioration in the real economy relative to the preceding half year, in view of the onset of the pandemic and the containment measures adopted by the government. The Bank of Israel’s assessments during the crisis pointed to a decline in private consumption of around 30 percent relative to the precrisis level and the shutdown of about 40 percent of the economy (in terms of GDP). Labor market data published during the period indicate that more than 1 million workers have applied for unemployment benefits. National Accounts data published during the reviewed half year indicate that GDP during the first quarter contracted less than initial estimates—by 6.8 percent in annual terms. The decrease in GDP reflected a decline in most uses. Overall, the real developments indicate that the Israeli economy is experiencing a recession that is unprecedented in the State of Israel.

The inflation environment: The decline in the inflation environment, which began already prior to the Covid-19 crisis, continued also during the crisis. The annual inflation rate remained below the lower bound of the target range during the period being reviewed. One-year inflation expectations declined from all sources—at first moderately, and since March, sharply.

The Monetary Committee assessed that the moderate decline in the inflation environment that occurred at the beginning of the period (prior to the crisis) did not reflect weakness of demand and that to a large extent it was influenced by the appreciation of the shekel and by inflation components characterized by high volatility. At the same time, the Committee was of the opinion that annual inflation would decline before rising back to the vicinity of the lower bound of the target range. Due to the spread of the pandemic, the Committee was of the view that there had been a significant decline in the inflationary environment, and that the decline incorporated two opposing trends: there was significant weakness in demand, in Israel and abroad, which was expected to reduce prices; yet in contrast, the adverse impact to the supply chain for various goods, was expected to bring about a rise in prices from the supply side. The Committee felt that the demand forces were dominant and that inflation would continue to fall.

Furthermore, the Committee assessed that it was difficult to interpret the inflation data due to problems in measuring goods and services that are temporarily unavailable due to the restrictions on economic activity and in view of the changes in the consumption patterns of households as a result of the crisis.

The exchange rate: Until March, the shekel continued to appreciate, and strengthened appreciably against most currencies. Following the turmoil in the financial markets, a sharp depreciation occurred in the shekel due to a shortage in dollar liquidity. As a result of the liquidity shortage, the Bank of Israel began to execute swap transactions with the goal of providing the required liquidity, thus leading to a drop in the shekel’s volatility and an appreciation of the shekel. Since then, the shekel has returned to its pre-crisis level.

Some of the Committee members were of the opinion that if the shekel stabilizes at that level, it will weigh on a recovery in exports and on the return of inflation to within the target range. During most of the surveyed period, the Bank of Israel continued to purchase foreign exchange, apart from during the period characterized by a shortage in dollar liquidity and a rapid depreciation.

The global economy: During the reviewed period, world trade data declined sharply. International institutions and investment banks expected global output to shrink, but were uncertain as to how much. The slowdown in global activity and in world trade led to a decline in commodity prices—with the price of oil reaching a new low relative to recent years and then partially recovering. As a result of the spread of the pandemic worldwide, many countries decided to adopt various monetary tools. Thus, many central banks initiated or expanded asset purchase programs and reduced their policy rate. In parallel to the monetary measures, many governments expanded their public expenditure and provided support for the extending of credit to the business sector. At the time of the May interest rate decision, the Monetary Committee continued to assess that the risks to the global economy remained significant, and in particular, the risk of a second wave of the epidemic.

Financial market developments: With the onset of the global crisis and the spread of the coronavirus worldwide, equity prices in Israel and worldwide declined sharply. The nominal and real yields on government bonds for the medium and long terms fell at the beginning of the half year, in line with the global trend. As a result of the turmoil in the financial markets in March, yields rose sharply but since then have corrected. According to the data as of the end of the period being reviewed, they have returned to the vicinity of the levels at the beginning of the year.

After the halt in issuances in the corporate bond market in March, there was a recovery in April and May. Bank credit grew during the crisis and the activity of state-guaranteed credit funds led to a drop in the average interest rate charged to small businesses. Prior to the interest rate reduction in April, and throughout the period, expectations based on the Telbor market and the professional forecasters’ projections[2] reflected a belief that policy would be even more accommodative in the future. In other words, there is a positive probability of an interest rate reduction. According to the most recent data, the expectation in the markets imply a high probability of an additional reduction in the interest rate during the coming year.

Fiscal policy: In the beginning of the half year, the deficit contracted due to, among other things, the budget restraint resulting from operating under an interim budget. Since then, the trend has reversed and the deficit has risen sharply, as a result of the fiscal measures that were declared by the government following the spread of the epidemic and the limitations that were imposed on movement and economic activity. According to the Research Department’s staff forecast, the deficit at the end of 2020 is expected to be roughly 12 percent of GDP, an increase of about 8 percentage points relative to last year.

The Committee assessed that the current level of the real interest rate enables the government to finance the deficit on convenient terms. Similarly, as long as the deficit is a direct result of the crisis, the financial markets will allow the government to continue financing it, even if it grows somewhat as a result of the additional policy steps to encouraging growth and productivity.

The housing market: The data available to the Committee members at the time of its decisions during the period did not yet reflect the effect of the crisis. The data available at those points in time indicated that activity was at a high level—home prices were increasing, alongside a high and stable level of housing transactions. Looking forward, there was uncertainty with regard to trends in the construction industry and in the housing market. In the short term, a decrease in housing stock is possible due to the delays in the issuing of permits, financing constraints, or a shortage in workforces and raw materials. In contrast, a drop in demand is possible in view of the rise in unemployment, uncertainty regarding employment, and the expectation of a drop in the rate of increase in wages or even a decline in wages. The initial estimate for April indicates a decline in the volume of transactions. A similar picture emerges from mortgage data, which indicates a drop in mortgage closures in April and May.

The Research Department’s staff forecasts: The Research Department published four forecasts during the period being reviewed in parallel to the interest rate announcements – in January, April, May and July.[3] The forecast changed notably during the period, in view of the spread of the coronavirus and the preventative measures adopted in Israel and worldwide.

In January, the forecast was that inflation in 2020 would be 1 percent and would continue to converge in the direction of the inflation target range in 2021. With respect to economic activity, some slowing in growth was expected as a result of the continuing slowdown in world trade and the reduction in the 2020 budget.

The forecast in April was revised markedly downward in view of the spread of the pandemic. The economy was expected to contract considerably in 2020 and subsequently was expected to recover rapidly in 2021. Regarding the unemployment rate, it was expected to gradually decline and would return to its low pre-crisis rate by the end of 2021. Inflation in 2020 was expected to be negative and in 2021 it was expected to approach the lower bound of the inflation target range.

In the updated forecast in May, the rapid removal of restrictions led to an upward revision of the growth path for 2020—a smaller contraction, of 4.5 percent. There was a downward revision regarding the recovery process, with a growth rate of 6.8 percent in 2021. The revised forecast for unemployment was 5.5 percent. As with the other changes in economic activity, expected inflation for 2020 was revised upward somewhat and for 2021 was revised downward.

In contrast, the growth path in July was revised downward in view of the increase in the rate of infection, which in turn led to a delay in the forecasted return of the economy to routine. The May and July forecasts for the interest rate remained unchanged (0.0–0.1 percent in another year).