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Background conditions

Inflation data: The Consumer Price Index (CPI) was unchanged in December; the average of the forecasts was for an increase of 0.1 percent. Monthly data on a seasonally adjusted basis indicate that in the second half of 2011 there was a significant slowdown in the pace of price increases, and in annual terms the increase was below the lower limit of the target inflation range. Inflation for the whole of 2011 as measured by change in the CPI was 2.2 percent, close to the center of the target range of price stability (1–3 percent per year). The primary sources of the increase in the CPI in 2011 were the energy, rent, and food components, which increased at a rapid pace in the first half of the year. Over the whole of 2011 energy prices increased 9.5 percent, rents by 5.2 percent, and food prices by 2.3 percent.
Inflation and interest rate forecasts: One year forward inflation expectations as calculated from the capital markets (break-even inflation) were 2.2 percent on average in January, a slight increase from the previous month. Inflation expectations for the medium term decreased slightly from the previous month, to 2.4 percent, and those for the long term remained 2.5 percent. Forecasters' inflation predictions for the next twelve CPI readings average 2.3 percent, similar to predictions last month. Expectations for the Bank of Israel interest rate one year from now, based on the Telbor (Tel Aviv Inter-Bank Offered Rate) market, remained steady at 2.4 percent, and the average of forecasters' predictions of the interest rate in one year's time increased to 2.6 percent, from 2.3 percent last month. Views differ among forecasters regarding the timing of the next interest rate reduction.
Real economic activity: Economic indicators that became available this month show a continued slowdown in activity and in demand. The Bank of Israel's Companies Survey for the fourth quarter indicates that business activity in the economy continued to grow at a moderate pace, similar to the previous quarter. The Central Bureau of Statistics monthly survey of business trends indicates a slowdown in business activity in December as well, continuing a slowdown trend which began in May 2011. The Purchasing Managers Index compiled by Bank Hapoalim and the Israel Purchasing and Logistics Managers Association declined in December to 42.7 points, continuing its November fall. The Composite State of the Economy Index increased 0.2 percent in December. The Central Bureau of Statistics Consumer Confidence Index for December indicates a negative balance of 20 percent, similar to its level of August 2011. Goods exports increased in December, compared with November, with some recovery in exports in high technology industries, while goods imports declined 1.2 percent.
The labor market: Labor market data indicate a high level of employment and a low unemployment rate. The rate of vacancies, which reflects demand for employees, was stable at about 3 percent. Nominal wages increased 4.3 percent in August–October, compared with the preceding three months, and real wages increased 1.2 percent. Health tax receipts, which provide an indication of total wage payments, were 2 percent higher in December in nominal terms than in December 2010 (excluding the effect of legislative changes), a marked moderation from the pace of increase in the last two years.
The Bank of Israel Research Department staff forecast: The Bank of Israel Research Department staff forecast compiled in December projects an inflation rate of 2.1 percent in 2012, and an average interest rate in the last quarter of 2012 of 2.2 percent. GDP growth in 2012 is projected to be 2.8 percent. The Research Department's assessment at the time of the forecast was that the housing component of the CPI (representing rents) will increase 4 percent in 2012.
Budget data: There has been a trend since April of a decline in indirect tax receipts, and in July a similar trend began in direct tax receipts. The overall government deficit (excluding net credit) in 2011 reached 3.3 percent of GDP, compared with a planned 2.9 percent of GDP, and was above the deficit ceiling of 3 percent of GDP. Given recent government commitments, particularly in light of the expected growth rate in 2012, 2.8 percent, which is lower than the 4 percent growth forecast on which the budget was constructed, the Ministry of Finance projects the deficit in 2012 to be 3.4 percent of GDP, compared with a deficit ceiling of 2 percent, set in the end of 2010.
The foreign exchange market: From the previous monetary policy discussion held on December 25, 2011, through January 20, 2012, the exchange rate of the shekel against the dollar was almost unchanged, in contrast with the strengthening of most major currencies against the dollar; the shekel appreciated by 1 percent against the euro. In terms of the nominal effective exchange rate the shekel remained nearly unchanged.
The capital and money markets: From the previous monetary policy discussion held on December 25, 2011, to January 20, 2012, the Tel Aviv 25 Index increased by 3.2 percent, similar to increases in stock market indices in advanced and emerging economies. The rates of interest on government bonds declined along the entire curve. Yields on unindexed government bonds dropped by about 5 basis points (b.p.) for most maturities, and yields on indexed bonds declined by 5–10 b.p. The yield gap between Israeli 10-year government bonds and equivalent 10-year US Treasury securities narrowed moderately to about 250 b.p. from 258 b.p. in the previous month. Makam yields decreased during the period by 5–10 b.p. along the entire curve, and the yield for one year decreased from 2.51 percent to 2.47 percent, this against the background of global trends and expectations of further cuts in the interest rate by the Bank of Israel, and despite the continued exit of nonresidents from makam. This month there were no net withdrawals from mutual funds specializing in corporate bonds. Israel's sovereign risk premium as measured by the five-year CDS spread remained nearly unchanged at 199 b.p. The Tel-Bond 20 Index increased by 1.5 percent, and the Tel-Bond 40 Index by 2.5 percent.
The money supply: In the twelve months ending in December, the M1 monetary aggregate (cash held by the public and demand deposits) increased by 2.4 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 10.6 percent.
Developments in the credit markets: The balance of outstanding debt of the business sector increased in November by 1.8 percent, to NIS 777 billion. Outstanding credit to households increased by 0.5 percent, to NIS 362 billion. The balance of outstanding housing credit to households increased by 0.5 percent in the twelve months to November to NIS 257 billion. Housing credit advanced in the twelve months which ended in December was 3 percent lower than that advanced in the twelve months to November, continuing the decline from the peak level in May. The share of unindexed floating rate mortgages granted in December was 26.9 percent. Interest rates on both price-indexed and nominal mortgages declined.
The housing market: Housing prices (rental rates), which are included in the CPI, declined by 0.1 percent in December. In the twelve months to December they increased by 5.1 percent, compared with an increase of 5.5 percent in the twelve months to November.
Home prices, which are published in the Central Bureau of Statistics survey of home prices but are not included in the CPI, declined in October–November by 0.3 percent, the third decline in succession. It seems that a trend change is taking place in the housing market. This month, too, the annual rate of increase in home prices moderated: in the twelve months to November home prices increased at a rate of 6.9 percent, compared with a rate of 8.5 percent in the twelve months to October, and rates of increase of about 20 percent in 2010.
Activity in the construction industry continues to be strong. There were 42,682 building starts in the twelve months to October, compared with 43,766 in the twelve months to September, and the number of completions was 34,313, compared with the previous month's figure of 33,652. However, based on partial data from the Bank of Israel Companies Survey, construction companies report a sharp increase in the difficulty of selling apartments.
The moderation in the rate on increase of 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, as well as land marketing efforts by the Ministry of Construction and Housing and the Israel Land Administration, is expected to continue to be reflected in the future.
The global economy: The macroeconomic data on the eurozone continue to indicate the start of a recession, the most prominent being Germany's negative growth rate of 0.25 percent in the fourth quarter of 2011. Investment houses' forecasts of growth in the eurozone in 2012 average a negative 0.7 percent, and concern over the negative impact of fiscal restraint on growth has increased. In contrast, relatively positive macroeconomic data on the US economy were published this month, in particular data relating to growth and employment, indicating a trend of recovery and growth. Most data on the emerging market economies published this month were better than those of the previous month, but they still show a slowdown in the rate of growth. Against the background of the European Central Bank (ECB) liquidity tender in December, and despite the downgrading of the credit rating of nine European countries, a positive atmosphere prevailed in the markets. This was evident in the successful issues of debt in European countries, including Italy, Spain and France, in the narrowing of the credit spreads of peripheral countries, and in rises in stock markets. Nevertheless, Greece's situation, against the background of the difficulties encountered in the attempts to restructure its debt arrangements, poses a threat.


Data on world trade show a continued fall in its volume in October, and forecasts of world trade growth were reduced. There was a very small increase in commodity prices this month, partly related to the developments regarding a boycott of Iran. Inflation forecasts for Europe and the US rose slightly this month, but are still very close to 2 percent.


The main considerations behind the decision
The decision to reduce the interest rate to 2.5 percent for February 2012 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, monetary policies of major central banks, and developments in the exchange rate of the shekel.
The following were the main considerations underlying the decision:
·         The indicators that became available this month show that the slowdown in activity and in demand that started during the second half of 2011 continues. The slowdown in growth of Israel's economy is seen in exports and in domestic demand, against the background of weakness in the global economy and the significant uncertainty existing in the global environment, primarily around Europe. In addition, surveys of expectations, both of consumers and companies, show that the slowdown in the rate of growth is expected to continue.
·         Actual inflation over the previous twelve months continues to settle firmly within the target range. Inflation figures indicate a marked slowdown in inflation in the second half of 2011. The Bank of Israel expects the rate of inflation over the previous twelve months to remain within the target inflation range in 2012. Forecasters' inflation predictions for the coming twelve months and inflation expectations measured from the capital market are close to the midpoint of the target range.
·         Data on economic activity in Europe are consistent with the assessments that the eurozone will slip into a recession in 2012. Figures of actual global trade show a continued volume decline in October. Forecasts for world trade growth in 2012 were revised downward. The risk of default of some European countries as reflected by the high yields on their bonds and their high CDS spreads were expressed this month in the downgrading of the sovereign credit rating of major European economies. Some optimism has been evident recently in global financial markets, primarily against the background of steps taken by the ECB, but uncertainty regarding the debt crisis remains high, which also affects the level of uncertainty about developments in the Israeli economy.
·         Interest rates in the major economies are low, and the markets are not pricing in an increase in the interest rate in the coming year in any of the central banks of the large advanced economies. The Fed, it will be recalled, declared that the federal funds rate will remain at a near-zero level till mid-2013 at least. The Bank of England and the ECB continued their efforts to increase liquidity.
·         Home prices continued to decline at a moderate pace. The limitation that the Bank of Israel imposed relating to the permitted share of housing loans at floating interest rates reduces the effect of cuts in the Bank of Israel interest rates on the average interest rate on mortgages.
The decision to cut the interest rate to 2.5 percent for February is consistent with the interest rate policy aimed at keeping inflation within the price stability target range and is intended to support real economic activity, against the background of the slowdown in global demand.
The Bank of Israel will continue to monitor developments in Israel's economy and the global economy and in 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 asset markets.
The minutes of the discussions prior to the above interest rate decision will be published on February 6, 2012.
The decision regarding the interest rate for March 2012 will be published at 17:30 on Monday, February 27, 2012.