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Monetary Policy Report 2011, January-Jun
Letter of the Governor accompanying the Monetary Policy Report for January–Jun 2011
Preliminary translation. Final version, with tables and diagrams, will be available within a few days.
Bank of Israel Jerusalem
August 2011
The Monetary Policy Report for the first half of 2011 (the period reviewed in this report) is submitted to the government, the Knesset, and the public as part of the process of assessing the inflation rate in relation to the inflation target set by the government. The Report was prepared in the Senior Monetary Forum of the Bank of Israel, headed by the Governor, the forum in which the Governor makes decisions on the interest rate.1
The Consumer Price Index (CPI) increased by 2.2 percent over the course of the first half of 2011. Contributing to the large increase (an annualized rate of 4.4 percent) was an increase of 3.5 percent in the housing component (representing rentals), as well as the food (4.4 percent) and energy (6.6 percent) components. The rise in prices during the period reviewed was affected by domestic factors, primarily housing, as well as by external factors—commodity and energy prices. In each month of the period reviewed, the price increase over the previous 12 months exceeded 3 percent—the upper limit of the 1–3 percent inflation target range. However, monthly figures (seasonally adjusted) show that in the last four months there has been a drop in the rate of price increases, compared with the months preceeding them.
The global recovery from the crisis of 2008 continues, with advanced economies growing slowly and emerging economies growing rapidly. According to an International Monetary Fund (IMF) forecast for 2011, advanced economies are expected to grow by 2.2 percent and emerging and developing economies are seen growing by 6.6 percent. In the period surveyed, commodity and crude oil prices rose, raising with them inflation forecasts for 2011 to 2.6 percent in advanced economies and 6.9 percent in emerging economies. With regard to interest rates, increases are not expected in the US in the coming year. In the eurozone, the European Central Bank (ECB) raised the interest rate for April and July by 0.25 percentage points each time, but there has been growing uncertainty there recently regarding the rate of growth and the future interest rate path; this stems from the increasing concerns over the debt crisis in several European countries which could also have an impact on global financial stability. The expanding national debt in most advanced economies and the high rate of inflation in emerging economies are expected to lead to policies of fiscal restraint (in advanced economies) and monetary tightening (in emerging economies), which may slow global growth. One of the expressions of these expectations is, apparently, a drop in prices of financial assets around the world in the period surveyed.
In the Israeli economy, the recovery in real economic activity and decline in unemployment continued in the first quarter of 2011. Growth was based on an increase in investment, as well as in exports, which were influenced by expanding global trade. Indicators for the second quarter point to a continued expansion of business activity, albeit at a slower pace than the first quarter.
In the period surveyed, prices of financial assets—mainly stocks and corporate bonds—fell, in line with similar developments of equity prices around the world. Nonetheless, house prices continued to rise in Israel—by 3.8 percent during the first four months of the year, and by 13.7 percent between April-May 2010 and April-May 2011. In light of the continued increase in the volume of variable rate mortgages, and in order to prevent the possibility of decline in the stability of banks, as of May 2011 the Bank of Israel limited the variable rate component to one third of each mortgage. A reporting requirement was also imposed on the banks, obliging them to advise borrowers who had already taken out housing loans at variable rates as to the effects of an increase in interest rates on their monthly payments.
In January, there was a marked depreciation of the shekel, apparently as a result of the growing instability in various Middle East countries, and as a result of steps taken by the Bank of Israel and the Ministry of Finance (see below). Later in the period surveyed, the appreciation of the effective exchange rate of the shekel resumed, due in part to the interest rate gap vis-à-vis the US and the eurozone. Overall, the shekel appreciated 0.8 percent during the period. In order to moderate the appreciation of the shekel, the Bank of Israel continued to buy foreign currency. At the same time, in order to moderate speculative short-term capital movements and increase financial stability, at the end of January, the Bank of Israel imposed on banking corporations a reserve requirement of 10 percent against nonresident transactions in foreign currency derivatives. The Bank of Israel also reported the imposing of a reporting requirement on transactions in foreign currency derivatives, and a reporting requirement on nonresident transactions in makam and short-term government debt, which came into effect at the beginning of July; this in order to track the entrance of capital into the economy. At the same time, the Ministry of Finance canceled nonresident investors' capital gains tax exemption in investments in makam and short term government notes, in order to moderate speculative capital flows.
During the period surveyed, the Bank of Israel accelerated the pace of interest rate hikes. The interest rate both for February and for March was raised 0.25 percentage points, the interest rate for April was raised 0.5 percentage points, and the interest rate for June was raised 0.25 percentage points, for a cumulative rise of 1.25 percentage points during the period, to a level of 3.25 percent in June. The reasons for the increases were the rate of inflation, measured over the previous twelve month period, which throughout the period was above the upper limit of the target range, the relatively high level of inflation expectations (for the next twelve months), both by forecasters and as derived from the capital market, as well as the continued economic growth, and the continued rapid rise in house prices. At the same time, the Bank of Israel continued to operate in the foreign currency market in order to moderate the appreciation pressures on the shekel. Toward the end of the period surveyed, the possibility of some slowdown in economic activity developed, and economic and financial uncertainty increased greatly, primarily in light of global developments and the regional geopolitical situation. Signs were also seen of a possible moderation in the rate of inflation. Against this background, the Bank of Israel kept the interest rate for July and August unchanged.
The Bank of Israel Research Department forecasts that Israel's economy will grow 4.8 percent in 2011 and that the unemployment rate will fall to an average for the year of slightly below 6 percent (down from 6.6 percent in 2010). Inflation, as measured by the change in the CPI, over the next four quarters (beginning in the third quarter of 2011) is expected to decline to 2.9 percent, and over the course of the second half of 2012 to remain within the target range. The Research Department estimates that the Bank of Israel interest rate will rise gradually to a level of 3.9 percent in the second quarter of 2012. According to the forecast, the key contributing factors to the increases in prices, and the increase in the interest rate, during the coming year are expected to be a continued rise in rents and the high level of prices of commodities and energy, which are expected to remain in place over the course of the year.
The Bank of Israel will continue to follow developments in Israel and worldwide, and to conduct policies which support growth and financial stability, at the same time as striving to return inflation to within the target range (expected, according to the Research Department staff forecast, during the course of 2012). The extent and timing of interest rate adjustments will be set according to inflation developments, the sustainability of growth in Israel and abroad, and developments in the exchange rate of the shekel, in asset prices, and in interest rates by leading central banks.
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1 Previously the Inflation Report. The name is changed to accord with the term in the new Bank of Israel Law that calls for a Periodic Report on Monetary Policy to be submitted by the Monetary Committee not less than twice annually. When the Monetary Committee is appointed, in accordance with the new Bank of Israel Law (5770-2010), interest rate decisions will be made by the Committee, and it will present the Monetary Policy Report.


Stanley Fischer

Governor, Bank of Israel

Summary*
  Inflation: In the first six months of the year, the Consumer Price Index (CPI) increased by 2.2 percent, and on a seasonally adjusted basis3 it increased slightly less, by 1.9 percent (which is an annualized rate of 3.9 percent). The main factors behind the higher index were rises in the price of food, energy, and housing (rentals). The increase in the rate of inflation, on a seasonally adjusted basis, was not uniform through the first half of the year. The inflation rate on an annualized basis was higher than the upper limit of the target inflation range in the first two months of the year, while in the months of March through June it was within the target inflation range. The pace of inflation over the previous 12 months, as well as 12 month forward inflation expectations, were above the upper limit of the inflation target range in each of the first six months. In June, at the end of the period surveyed, inflation expectations began to decline, and in July they dropped slightly below the upper range of the inflation target range.
  The global economic environment: During the course of the period reviewed (the first half of the year) most countries in the world recorded positive growth, and this found expression in an increase in world trade. With that, against the background of high debts in some advanced economies, along with a rising rate of inflation in emerging economies, policies of fiscal and monetary restraint are expected. These policies are liable to slow the pace of global growth. The International Monetary Fund (IMF), in its most recent survey, noted that in its opinion, growth forecasts for 2011 and 2012, which will be published over the coming months, will be revised downward. Due to the increase in the pace of inflation, emerging economies continued to raise monetary interest rates. In contrast, the US is only expected to raise the fed funds rate at the end of 2012. In the eurozone, the interest rate was raised twice since the beginning of the year, in April and July. With that, in light of the debt crisis in several countries in Europe, the pace of interest rate hikes in the eurozone is expected to be moderate.
  Real economic activity: Economic activity continued to expand in the first quarter of 2011, and GDP grew 4.6 percent (annualized rate, seasonally adjusted). The increase was contributed to primarily by a 26.1 percent increase in investment in fixed assets, and a 12.0 percent increase in exports. Indicators of second quarter economic activity point to continued expansion, albeit at a more moderate pace.
  Exchange rate: The nominal effective exchange rate reflected significant depreciation of the shekel in January, against the background of geo-political uncertainty in Arab countries, and policy measures by the Bank of Israel and the Ministry of Finance. The shekel then continued its appreciation, similar to its trend in 2010. The appreciation trend continued, among other things, against the background of a widening interest rate gap between Israel and developed economies. Bank of Israel activities in the foreign currency market and policies intended to restrain the inflow of short term capital into Israel weakened the shekel appreciation pressures. By the end of the first half of the year, the shekel showed a moderate appreciation of 0.8 percent.
  Financial markets: In the first half of the year, against the background of increasing uncertainty in the world and rising interest rates in the economy, equity prices reversed course and they began to decline. Yield spreads between CPIindexed corporate bonds and CPI-indexed government bonds responded with a delay to developments in financial markets, and despite widening recently, they remain low. The expansion of credit to the business sector continues. According to the Bank of Israel Companies Survey, it appears that companies are not facing credit constraints.
  Mortgages and house prices: House prices continued to rise at a rapid pace. In the first four months of the year, the index of house prices rose 3.8 percent, and in the past 12 months it rose 13.7 percent4. The rapid pace of increase of home prices is expressed in the widening gaps between house prices and rental levels and between house prices and average wage levels. In light of the continuing rise in the volume of variable rate mortgages, the Bank of Israel limited, beginning in May 2011, the proportion of a mortgage at variable rate interest. In addition, the directive imposes on the lenders a disclosure requirement, according to which they must notify customers who took out a mortgage with a variable interest rate, based on the prime interest rate, not indexed to the CPI. This was with the goal of increasing banks' and the public's awareness of the consequences of a rise in the interest rate on the ability of mortgage borrowers to repay their loans.
  Monetary policy: During the first half of 2011, the Bank of Israel accelerated the pace of interest rate hikes. The Bank of Israel raised its interest rate during this period by a total of 1.25 percentage points, to a level of 3.25 percent. The pace of inflation over the previous 12 months, and inflation expectations above the upper limit of the target range, the rapid growth of real local economic activity and the increase in house prices all supported an increase in the monetary interest rate in order to return inflation to within the target range and maintain financial stability. At the same time, the Bank of Israel operated in the foreign currency market in order to restrain the appreciation pressures on the shekel. Bank of Israel activity in the foreign currency market included purchase of foreign currency, and the publication of macro-prudential policy directives, including imposing on bank corporations a reserve requirement of 10 percent against nonresident transactions in foreign currency derivatives, and imposing a reporting requirement on various transactions.
  Forecast: The Research Department staff forecast is that inflation in the next twelve months will be 2.9 percent, slightly below the upper limit of the inflation target range. The inflation rate over the next twelve months' being at the upper limit of the target inflation range is explained by the continued rise in the housing component (rents) and stronger demand, as well as by the increases in recent months in the prices of commodities and energy. The economy is expected to grow at 4.8 percent in 2011 and at 3.9 percent in 2012. The forecast is that the interest rate will rise gradually to about 3.9 percent over the next year, as part of Bank of Israel policies to return inflation to within the target range.
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* The monetary regime within which the Bank of Israel operates is aimed at achieving price stability, defined as an inflation rate of between 1 percent and 3 percent a year. (For details see Box 1 in the Bank of Israel Inflation report No. 17, July–December 2005.)
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