In an surprise move this week, Bank of Israel Governor Stanley Fischer raised Israel's base interest rate by double the expected amount to 3.0% - compared to the U.S. rate of 0-0.25%. Israeli government and corporate bonds increased their annual yields as a result, making these bonds even more attractive to foreign investors. Below are the reasons the Bank gave for this unanticipated jump, and a good overall picture of the strength of the Israeli economy.
Inflation data: The February CPI rose by 0.3 percent, more than the average predicted increase, and above the seasonal path consistent with the achievement of the inflation target, which would have required a reduction in the index of 0.1–0.2 percent. The inflation rate, measured over the previous twelve months, continued to increase, and in February reached 4.2 percent. The CPI excluding the housing price component rose by 3.5 percent in the previous twelve months.
Inflation and interest rate forecasts: The average of forecasters' inflation expectations for the next twelve monthly CPIs increased from 3 percent to 3.1 percent, slightly above the upper limit of the target inflation range. Expectations calculated from the capital market averaged about 3.7 percent in March, above the upper limit of the target inflation range. Medium- and long-term inflation expectations were steady this month, slightly above the upper limit of the target inflation range. Forecaster’s predictions and the Bank of Israel Research Department staff forecast of inflation in the next twelve months are that it will remain above the target range during the rest of 2011, and that it will decline at the beginning of 2012 to the upper limit of the target range. Based on the Telbor market (Tel Aviv Inter-Bank Offer Rate), the Bank of Israel interest rate in a year’s time is expected to be 4.1 percent, and on average, forecasters' predictions are that it will be 3.9 percent. Most forecasters expect the Bank of Israel to increase the interest rate for April 2011, and the others expect no change.
Real economic activity: Most economic indicators that became available this month show that domestic activity continued to expand. The updated National Accounts estimate for 2010 confirms the original positive estimate published in February: GDP grew by 4.6 percent in 2010, and in the fourth quarter it grew at an annual rate of 7.7 percent. The February composite state-of-the-economy index rose by 0.4 percent, indicating continued growth, expressed by further increases in domestic demand and demand for exports. Goods exports increased by 4.6 percent in February (seasonally adjusted), following the increase of less than 1 percent in January. Services exports surged by 7.7 percent in January, after falling by 5.6 percent in December. In the months from November to January total revenue of all industries increased at an annual rate of 4.9 percent, further to the rise of 3.5 percent (annual rate) in the previous three months. In contrast, indices of consumer confidence and the purchasing managers index declined in February, after remaining steady in the four previous months; this was due to the rise in geopolitical uncertainty and the increase in commodity prices. The Bank of Israel Research Department index of the probability of a slowdown in domestic demand, based on Google searches, increased slightly, to 38 percent, still below 50 percent.
The labor market and wages: The unemployment rate stayed at 6.6 percent in the fourth quarter of 2010, with the employment rate and the rate of participation in the labor force increasing marginally, by 0.1 percent. According to trend data, the rate of unemployment dropped to 6.1 percent in January. Another positive indicator from the labor market is the strengthening of the trend from part-time to full-time employment. The nominal wage increased by 3.7 percent in 2010, and the real wage by 1 percent. Health tax receipts in February 2011, which provide an indication of wage payments in that month, show an increase of 4.7 percent, in real terms, from their level in February 2010.
The Bank of Israel staff forecast, which was updated this month, is that inflation in 2011 will be above the upper limit of the target inflation range, with the interest rate increasing gradually to about 4 percent in a year’s time. The main risks to real activity and inflation in Israel derive from developments abroad, including the increase in commodity and oil prices, and in the local housing market, and from the realization of geopolitical risks.
Budget data: Government expenditure in January–February was 7 percent higher in real terms than in January–February 2010, but was lower than the seasonal level consistent with full expenditure of the budget. Since the beginning of the year, the overall cumulative government surplus in the budget totaled NIS 2.8 billion, about NIS 2 billion higher than the seasonal path consistent with remaining below the deficit ceiling. Tax revenues in January–February, after accounting for the effects of legislative changes and nonrecurring receipts, were 9 percent higher, in real terms, than in the first two months of 2010. Tax revenues in February were in line with the seasonal path consistent with the budget forecast.
The foreign exchange market: From the previous monetary policy discussion held on February 20 until March 25, the shekel appreciated by 1.9 percent against the dollar, and depreciated by 2.4 percent against the euro, similar to the changes in other currencies around the world. In terms of the nominal effective exchange rate the shekel remained unchanged.
The capital and money markets: Between the monetary policy discussions of February 20 and March 25, the Tel Aviv share price indices fell, as did most stock market indices around the world. The Tel Aviv 25 index dropped by 3.8 percent, and the Tel Aviv 100 index by 4.6 percent. Yields on government bonds increased in this period, against the background of the latest increase in the interest rate, expectations of faster rates of increase in the interest rate, and geopolitical uncertainty. Over the period the yield on makam increased along the entire curve. The amount of nonresidents’ activity in the makam market declined this month. Yields on local currency bonds increased along the entire curve by between 16 b.p. and 26 b.p. Yields on CPI-indexed government bonds also increased, with the curve flattening somewhat. The yield gap between Israeli and US unindexed 10-year government bonds widened this month, and reached 189 b.p. The corporate bond market was affected by an increase in risk aversion, but remained relatively stable, due to the limited supply in this market, a result of the recommendations of the Hodek Committee. The Tel-Bond indices showed only small movement: the Tel-Bond 20 index dropped by 0.2 percent, and the Tel-Bond 40 by 0.1 percent. The gap between the Tel-Bond indices and 10-year CPI-indexed government bonds widened just a little, by about 2 b.p, as yields on government bonds also increased. Israel's sovereign risk premium as measured by the five-year CDS spread increased this month, and reached 176 b.p., but then declined to 153 b.p.
The money supply: In the twelve months to February the M1 monetary aggregate (cash held by the public and demand deposits) increased by 7.3 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 6.8 percent.
The credit market: Total outstanding housing credit increased by 0.8 percent in February, and in the twelve months to February it increased by 13.1 percent.. Total new mortgages advanced in February increased by 0.7 percent, following their 14.3 percent decrease in January. The amount of mortgages granted in the twelve months to January continued to be high––about NIS 50 billion. The rate of interest on mortgages of all types increased again this month, against the background of the increase in the Bank of Israel interest rate, among other things.
The housing market: House prices––which are presented in the Central Bureau of Statistics survey of house prices but are not included in the CPI––continued to increase, and in December–January they increased at a rate of 0.9 percent a month, following their increase of 1.3 percent a month in November–December. In the last twelve months house prices increased by 16.3 percent, compared with a level of 17.5 percent in the previous month. The housing price index, which is based mainly on renewed rental contracts and which is included in the CPI, rose by 0.4 percent in February. In the last twelve months the housing price index increased by 6.5 percent, a faster rate than in recent months.
The global economy: The latest indicators show continued global economic growth in the first quarter of 2011, with growth becoming more firmly entrenched in the US and improved performance in the major European economies. Nevertheless, a series of shocks, including natural disasters, starting with the earthquake and tsunami in Japan, political turmoil in several Arab countries, and persistent concern over the debt crisis in some European countries, keep raising the level of uncertainty and cast a shadow over the forecasts of global growth. The general view at this stage is that the effect of most of these shocks will be temporary. Nonetheless, the implications for the supply of energy resources are likely to be significant and long term, and are likely to impact on future growth. At the same time there is greater concern regarding the acceleration of inflation around the world against the background of the continued considerable increases in oil and other commodity prices. The ECB (European Central Bank) is expected to increase its interest rate in another month. Inflationary pressures resulted in many central banks, including those of Brazil, Chile, India and Russia, increasing their interest rates this month.
The main considerations behind the decision [to raise the interest rate]
The decision to increase the interest rate for April by half a percentage point to 3.0 percent is consistent with the process of returning the interest rate to a normal range intended to position inflation firmly within the target range, and to support the further recovery of economic activity, while maintaining financial stability. The rate of increase in the interest rate is not pre-determined, but is set in accordance with the inflation environment, growth in Israel and globally, the monetary policies of the leading central banks, and developments in the exchange rates of the shekel. At the current level of the interest rate, monetary policy continues to be expansionary.
- The CPIs in the last few months exceeded the forecasts. Inflation over the previous twelve months is 4.2 percent, above the target range. Inflation forecasts—of the Bank of Israel, forecasters, and those derived from the capital market—continue to be high. According to those forecasts, inflation over the previous twelve months is expected to remain above the target range throughout 2011 and to return within the target range at the beginning of 2012. In addition, inflation expectations for periods longer than a year as calculated from the capital market are still above the upper limit of the inflation target range. Forecasters’ inflation predictions also take into consideration an expected increase in the interest rate for April.
- Economic indicators published this month show that domestic activity continued to expand, converging towards a situation of full utilization of the factors of production. Updated National Accounts figures for 2010 confirm the positive picture painted in February; they showed growth in the fourth quarter of 2010 at an annual rate of 7.7 percent. Economic recovery is continuing world wide, including in the US and in some European countries. Nevertheless, the disaster in Japan, the geopolitical situation in the Middle East, and the debt crisis of some European countries increase uncertainty regarding future global growth.
- House prices continued to increase this month; in the last twelve months they have risen by 16.3 percent. No decline in the volume of new mortgages is evident.
- Central bank interest rates in the major advanced economies are still low. At the same time, the expected timing of an increase in the Fed interest rate has been brought forward, and the European Central Bank is expected to increase its interest rate soon. In addition, against the background of faster inflation in the emerging market economies, a relatively large number of central banks increased their interest rates this month.
The Bank of Israel will continue to monitor developments in Israel's economy and the global economy and in the financial markets. The Bank 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, including keeping a close watch on developments in the assets market, and especially in the housing market.
Source: Bank of Israel Press Release, March 28, 2011 - Office of the Spokesperson and Economic Information
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