Monday, March 31, 2008

The Israeli Economy Grows.

The Bank of Israel cuts the interest rate for April 2008 by 0.5 percentage points to 3.25 percent

The Bank of Israel announces that the interest rate for April 2008 will be reduced by 0.5 percentage points, to 3.25 percent. This step is taken in the context of the policy of maintaining price stability, in accordance with the inflation target of 1–3 percent a year.
Background conditions
Inflation data: The Consumer Price Index (CPI) fell by 0.2 percent in February, in line with earlier estimates, and rose by 3.6 percent in the last twelve months. The easing of energy prices in January and the appreciation of the shekel in the last few weeks acted to lower the February CPI, while the rise in food prices had the reverse effect. In the last twelve months the CPI excluding the energy and food components rose by only 0.9 percent.
Inflation and interest rate forecasts: Israeli forecasters expect, on average, that inflation in the next twelve months will be 2.7 percent, and that the interest rate for April will be cut by between a quarter of a percentage point and one percentage point; on average they expect a reduction of 0.5 percentage points in the interest rate. Inflation expectations for the next twelve months derived from the capital market rose from 2.4 percent in February to 2.7 percent in March. At the same time, expectations regarding the interest rate, derived from the capital market, are for a reduction in the next few months. Since the Bank’s different econometric models indicate differing scenarios, they received less than their usual weight in the discussions prior to this interest rate decision.
Real economic activity: The rapid rate of growth in Israel’s economy in the last few years continued and even strengthened in the last quarter of 2007, when GDP and business sector product increased by 6.1 percent and 7.7 percent respectively, in annual terms. Spearheading the growth in that quarter was the acceleration in exports and in investment. The composite state-of-the-economy index for February rose by 0.4 percent, indicating continued expansion, albeit at a lower rate than in 2007. Global economic developments, on the other hand, increase the probability of a lower rate of growth––less than 3.5 percent––in contrast to the rate of more than 5 percent recorded since the middle of 2003. The expected slowdown in Israel’s growth reflects the decline in exports and in private consumption expected to result from the slowdown in the global economy.
The labor market and wages: In the last quarter of 2007, unemployment fell to 6.7 percent in the last quarter of 2007, and the real wage and unit labor costs remained unchanged. The nominal wage rose by 2.9 percent in that quarter relative to the same quarter in 2006.
Budget policy: In February the domestic deficit totaled NIS 0.5 billion. Based on the seasonal path, the level hitherto is consistent with meeting the deficit target of up to 1.6 percent of GDP. Direct tax revenues fell by 12.1 percent compared with the corresponding period in 2007. The drop in direct tax revenues resulted mainly from unusually high non-recurring tax receipts at the beginning of 2007, and from the cuts in tax rates. Excluding the effect of these factors, tax revenues in the first two months of 2007 are higher than those expected in the budget forecast. The upward trend in revenue from indirect taxes continued.
The foreign exchange market: The strengthening of the shekel that started in mid-December 2007 continued, and in the period between the previous interest rate decision on 25 February and 23 March the shekel appreciated by 5.4 percent against the dollar, and by 1.5 percent against the euro. In the days immediately following the cut in the Bank of Israel interest rate for March 2008, the shekel weakened against those two currencies, but then strengthened again. Between March 10 and 12 it strengthened to an abnormal extent until the Bank’s intervention in the foreign exchange market on 13 and 14 March. Following that intervention, the shekel weakened against both the dollar and the euro. In that period most of the major currencies strengthened against the dollar, by up to 5 percent. Unlike in the previous month, the volatility of the shekel/dollar exchange rate declined this month. Trading in the foreign currency market stayed at about the same level as in the previous month––about $2.1 billion a day. On 20 March the Bank of Israel announced its intention to increase its foreign exchange reserves by about $10 billion by purchases of about $25 million a day on the market over the next two years.

The capital and money markets: Between the previous interest rate discussion on 25 February, and 23 March, the indices of the leading stock exchanges abroad recorded declines of up to 9 percent; the Tel Aviv 100 share price index fell by 8.6 percent. Yields on 10-year unindexed government bonds dropped again this month, to 5.63 percent, compared with 5.77 percent last month. The yield gap between these bonds and comparable US government bonds widened this month to 2.3 percentage points (compared with 1.9 percentage points last month). Israel's sovereign risk premium as measured by the five-year CDS premium continued to rise, and reached 0.9 percent, up from 0.8 percent prior to the previous interest rate decision. The CDS spread widened markedly also in the other emerging markets, and surpassed the levels prevailing at the start of the crisis.

The world economy: Macroeconomic data relating to the US economy indicate a significant deterioration, and expectations are for growth rates of less than one percent in both 2008 and 2009. At the same time commodity and energy prices continued rising steeply. The assessment by the Federal Reserve, however, is that the expected slowdown in the US will lead to a decline in inflation, so that its policy is essentially directed towards counteracting the economic slowdown and the liquidity crisis. At their last meeting, on 18 March, the Fed cut the interest rate by 0.75 percentage points to 2.25 percent, and the markets expect a further cut of about 0.5 percentage points in the next few months. The ECB, on the other hand, continues to regard inflation as the major risk, and it is therefore not expected to cut its interest rate. It should be noted that in contrast to the recent trend, most commodity and energy prices fell sharply in the last few days, and at the same time inflation expectations based on these prices also dropped. Since the beginning of March, the credit markets have deteriorated further.

The main considerations behind the decision

The decision to cut the interest rate for April by 0.5 percentage points is consistent with a return of inflation to within the target range of 1–3 percent inflation in the second half of the year.

The forces that served to moderate price increases last month––mainly the higher probability of a slowdown in the global economy and the strengthening of the shekel––continued to do so this month even more strongly. The increased intensity of these forces derives from the following:

In light of the latest forecasts of a more severe slowdown in growth in the US and in the global economy, and hence of a slower expansion of world trade, the assessments of a slowdown in Israel’s growth rate––and its effect in moderating inflationary pressures, among other things by reducing both the demand for exports, mainly to the US, and domestic demand––have firmed.

The degree of the strengthening of the shekel against other currencies since mid-December 2007 in itself acts to lower the pressures for price increases in the next few months, despite the weakening of the link between changes in the dollar exchange rate and the CPI.

The global interest rate environment has fallen and is expected to continue to fall further. Thus a reduction in the Bank of Israel interest rate is required this month too due to the moderating effect on price rises in Israel of the interest rate differentials between Israel and abroad, via the strengthening of the shekel.

Subject to the reduction in inflationary pressures, as described above, and taking into consideration the Bank of Israel’s assessments that inflation will return to within the target range this year, the 0.5 percentage point cut in the interest rate is likely to support continued economic growth and employment.

The Bank of Israel will continue to monitor domestic and world economic developments closely with the intention of achieving the price stability target. Subject to this, the Bank will continue to support the attainment of a range of objectives of macroeconomic policy, in particular the encouragement of employment and growth. In addition, the Bank will continue to support the stability of the financial system.


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