The Bank of Israel announces that the interest rate for June 2010 will remain unchanged at 1.5 percent.

Background conditions

Inflation data: The CPI for March rose by 0.9 percent, slightly more than the forecasts, which were for an increase of between 0.6 percent and 0.8 percent. The most notable rise was that of the housing component, which increased by 1 percent. Inflation in the last twelve months was 3 percent––the upper limit of the target inflation range––and excluding the effects of government actions (the changes in indirect taxes and the water surcharge), inflation was 2.6 percent.

Inflation and interest rate forecasts: The rate of inflation expected over the next twelve months (May 2010 to April 2011), both by forecasters and as derived from the capital market, did not change from the previous month, and averaged 2.7 percent. Forecasters’ expectations of inflation in 2010, however, increased slightly, to 1.9 percent. In the next three months the forecasters, on average, expect a cumulative increase of 1 percent in the CPI, so that inflation measured over the previous twelve months will continue to decline towards the midpoint of the target range. With regard the expected Bank of Israel interest rate a year hence, expectations calculated from the capital market are for an interest rate of 2.6 percent, and forecasters’, on average, expect a rate of 3.0 percent.

Real economic activity: Most indicators show that real economic activity continued to expand this month, with some indications that the rate of increase has slowed somewhat. According to the recently published National Accounts data for the first quarter of 2010, GDP grew at an annual rate of 3.3 percent, and business sector product at a rate of 4.8 percent. The GDP growth rate is slightly below the forecasts, but it is important to bear in mind that this is an initial estimate of a quarterly figure. The National Accounts figures show a decline in services exports, a continued reduction in investments, and a continued slowdown in the increase of private consumption that resulted from a drop in purchases of durables. The Bank of Israel composite state-of-the-economy index for April rose by 0.1 percent, indicating continued, but slower, expansion. Concern mounted this month that the debt crises of several European countries would have an adverse impact on the recovery in the eurozone and in the global economy. The share of Israel’s total exports directed towards the countries under market pressure is relatively small (5 percent), but if the crisis spreads to the whole of the EU, which constitutes an important market for Israel’s exports (28 percent of exports), it could have a significant impact on Israel’s exports.

The labor market and wages: Various indicators taken together suggest continued improvement in the labor market. Data from the Ministry of Industry, Trade and Labor Employers’ Survey shows that the demand for workers increased in the first quarter of 2010, for the third quarter in succession. That said, demand remains significantly lower than its level in the years 2006–08. The data on Health Tax revenues in April indicate continuing increases in wage payments. The real wage rose by 2.2 percent, annual rate, in the period December 2009 to February 2010 compared with the previous three months, the nominal wage increased by 4.2 percent, and the number of employee posts increased by 2.3 percent.

Budget data: In the first four months of 2010 the domestic deficit was NIS 3.2 billion, compared with NIS 6.6 billion in the first four months of 2009. The deficit in January–April 2010 is NIS 3 billion lower than that given by the seasonal path consistent with the budget deficit ceiling. Based on the expenditure of the budget since the beginning of the year, it is expected that the deficit in 2010 will be markedly lower than the ceiling specified in the budget––5.5 percent of GDP.

The foreign exchange market: In the period from the previous monetary policy discussions of April 25 to May 23, the shekel depreciated by 2.1 percent against the dollar, and appreciated by 3.6 percent against the euro. The background to this development was the relatively rapid strengthening of the dollar against the euro, as a result of the debt crises in Europe. In terms of the nominal effective exchange rate, the shekel strengthened by about 1.6 percent, as a result also of its appreciation against the other currencies included in the currency basket against which the rate is calculated.

The capital and money markets: Between the monetary policy discussions of April 25 and May 23, the Tel Aviv 25 index dropped by 7 percent, and the Tel Aviv 100 index by 8 percent, in line with the reductions in the major stock markets around the world. The yields on Israeli government bonds declined this month along both the nominal and indexed yield curves, mainly in the short part of the curves, so that the curves became steeper. The yield gap between Israeli and US unindexed 10-year government bonds widened again this month, by 44 b.p., to 158 b.p., as a result of sharp drops in yields in the US. There was continued lively interest in makam among foreign investors, who continued to expand their activity in the secondary market, in which there is active trade. Yields to terms up to 9 months increased, while those to longer terms declined, and the curve flattened. The Tel-Bond 20 index rose by about 0.3 percent over the period, while the Tel-Bond 40 index fell by about 0.6 percent. Israel’s sovereign risk premium, as measured by the five-year CDS spread, increased a little this month, in line with the increases in risk premiums around the world, and reached 125 b.p, an increase of about 14 basis points from the level in the previous month.

The money supply: The M1 monetary aggregate (cash held by the public and demand deposits) increased by 1.9 percent in April, following its increase of 1.8 percent in March; in the last twelve months it increased by 14.9 percent. The M2 aggregate (M1 plus unindexed deposits up to one year) expanded by 1.2 percent in April, following its fall of 1.1 percent in March; in the last twelve months it increased by 3.9 percent.

The credit market: Total outstanding business sector credit decreased in March by 1.2 percent, to NIS 727 billion. Of this, bank credit accounted for NIS 387 billion, a drop of 0.5 percent compared with the February level. Outstanding nonbank credit declined by 2 percent.

The housing market: Housing prices continued to increase: between March 2009 and February 2010 they rose by 21.9 percent, according to the house price survey, and the housing index in the CPI (based on the rental cost of apartments) increased by 5.1 percent. The rapid rate of increase of the price of housing was due both to the low rate of interest and to the supply constraint. Housing credit increased in March by 0.9 percent, to NIS 159 billion; in the last twelve months it increased by 13.5 percent. At the beginning of 2010 unindexed floating interest rate mortgages constituted 30.5 percent of all mortgages, compared with 15.6 percent at the beginning of 2008; the share of CPI-indexed floating interest rate mortgages was 25.6 percent, compared with 22.6 percent at the beginning of 2008.

The global economy: During the last month the debt crises in some European countries cast a cloud over the recovery trend evident in the global economy since the second half of 2009. The reversal in the markets occurred with the downgrading of the credit ratings of Greece, Portugal and Spain. As a result, there were steep falls in share markets and sharp increases in bonds yields in several European countries, in contrast to large declines in yields on German and US bonds. On May 10, the EU and the ECB, in conjunction with the IMF, produced a program that calmed the markets somewhat. As part of the program, the ECB injected liquidity into the bond markets. In contrast to these financial developments, real economic activity––led by the business sector––in the US, Europe and other leading economies, continued to increase, and companies’ financial statements for the first quarter of the year were good. Among the investment houses the consensus is that the European debt crises are expected to lead to a decline in demand, fiscal tightening in many countries, and a negative impact on the recovery. The crisis led to a significant decline in energy and commodity prices, and inflation in most advanced economies remains low. The weakness of European currencies and sterling, however, is likely to boost inflation to some extent in those countries, while also increasing their exports. The major central banks kept their interest rates basically unchanged, and even reintroduced some of their unconventional instruments. It appears that the increases in interest rates that were expected to take place in the next few months will be delayed.

The main considerations behind the decision

The decision to keep the interest rate for June unchanged at 1.5 percent is consistent with the gradual process of returning the interest rate to a more “normal” level, intended to position inflation firmly within the target range, and to contribute to the further recovery of economic activity, while supporting financial stability. The path of the interest rate will be determined in accordance with the inflation environment, the entrenchment of growth in Israel and globally, the rate at which the major central banks increase their interest rates, and in light of developments in the exchange rates of the shekel. At the current level of the interest rate, monetary policy continues to be expansionary.

Following the publication of the April CPI, inflation since the beginning of the year was 0 percent, and in the last twelve months was at the upper limit of the target inflation range. The inflation rate over the last twelve months is expected to decline to the middle of the range in the next few months. Twelve-month forward inflation expectations, both of forecasters and those calculated from the capital market, remained unchanged from the previous month, and average 2.7 percent. The reductions in commodity and oil prices around the world are expected to moderate inflation in the coming months.

Data regarding real economic activity in Israel that became available this month, in particular business sector product in the first quarter of the year and labor market data, continue to support the assessment that economic activity is on a rising trend, although there are signs of a slowing in the rate of increase in activity. The level of uncertainty increased this month against the background of concern that the debt crises in some European countries would cast a cloud over the recovery in the advanced economies, and would thus have a negative impact on economic activity in Israel.

Interest rates of the central banks of the leading advanced economies are very low, and in light of the latest developments are expected to remain so longer than originally anticipated. In addition, some of the unconventional instruments of monetary accommodation have been reintroduced.

In light of the continued rapid increase in housing prices and the steep rise in housing credit, due partly to the low level of interest, and in order to moderate these trends and to support financial stability, the Supervisor of Banks today issued draft guidelines to banks to exercise strict checks on housing credit, and imposing additional provisions for housing loans with high a loan-to-value ratio.

Taking into account the above considerations, the Governor decided to leave the interest rate unchanged.

The Bank of Israel will continue to monitor Israeli and worldwide economic and financial developments, and will use the instruments 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.

(YWN Israel Desk – Jerusalem / Bank of Israel)