Monetary Policy Report Second Half of 2023

This report surveys monetary policy during the second half of 2023.

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Monetary policy: During the second half of 2023, the Bank of Israel kept the interest rate unchanged at a restrictive level of 4.75 percent. At the beginning of 2024, on January 1, the Monetary Committee decided to reduce the interest rate by 0.25 percentage points, to 4.5 percent. Until the war erupted at the beginning of October, the policy had been operating in an environment of a depreciating trend of the shekel, against the background of increasing uncertainty regarding the impacts of the proposed legislative change on the economy, alongside above-target inflation. In the second part of the half year, in view of the war that began on October 7, the monetary policy focused first on stabilizing the financial markets, particularly the foreign exchange market, and in reducing the uncertainty. This was alongside maintaining price stability and supporting economic activity. Accordingly, the Committee implemented a program to sell foreign exchange, and pursuant to the Governor’s decision, it also activated a plan to supply liquidity in the swap and repo markets. In addition, the Bank of Israel put into operation a focused program of monetary loans aimed at easing credit terms for small and micro businesses that were negatively impacted by the war. These steps came in addition to the broad framework promoted by the Banking Supervision Department to defer repayments on loans from banks and credit card companies to households.

 

Domestic real activity and the labor market: The third quarter of 2023 was characterized by some slowing of activity, while the labor market remained tight. At the beginning of the fourth quarter, the “Swords of Iron” War broke out, and its impacts were felt on both the supply and demand sides; a decline in current consumption, absence of employees from workplaces due to reserves duty and the closing of educational institutions; and a marked adverse impact on the construction and agriculture industries, as well as the tourism, entertainment, and leisure industries. Supply limitations alongside the marked decline of demand in the beginning of the war were reflected in a decrease of private expenditure and in a marked decline in the scope of business sector revenues. The most severe adverse impact was on the food services and the construction industries. Later in the quarter, some recovery in activity was seen: credit card expenditures returned to routine levels, and the level of mobility in the economy improved considerably. Flash surveys by the Central Bureau of Statistics also indicated a notable improvement in employment in all industries examined, particularly in view of the renewed opening of the education system; at the end of the half year, in some industries there was a recovery in the job vacancy rate, which had declined significantly with the war’s eruption.

 

The inflation environment: During the reviewed half year, the year over year inflation rate moderated gradually, in both the tradable component and the nontradable component. With the interest rate decision on January 1, 2024, the year over year inflation rate declined to 3.3 percent (based on the CPI for November, which is what was known at the time), after having been 5.4 percent in January 2023. The annual growth rate of the core CPI (excluding fruit and vegetables and energy) declined to 2.9 percent. It appears that the war did not contribute to an increase in inflation in the immediate term. In contrast to previous security occurrences, 1-year inflation expectations declined at the beginning of the war, but later on returned to their pre-war level. The interest rate path expected according to the Telbor curve declined during the reviewed half year, and at the end indicated an interest rate of 3.4 percent in another year. This is in contrast to a level of 4.6 percent just before the war. After the decision that was reached at the beginning of January, the last decision covered by this report, the CPI for December 2023 was published, indicating that the inflation rate was 3 percent in 2023. This means that the inflation rate entered the price-stability target range set in the Bank of Israel Law, against the background of the restrictive monetary policy as described in the report.

 

Exchange rate: With the eruption of the war, Israel’s risk premium increased sharply, and the shekel depreciated markedly against the dollar and euro. In order to moderate the fluctuations in the exchange rate and to supply the liquidity required for continued orderly activity of the markets, the Bank of Israel announced, before the first trading day after the war broke out, a program to sell up to $30 billion of foreign currency. Within the framework of that program, the Bank of Israel sold $8.2 billion in October and approximately $338 million in November. At the beginning of November, the trend reversed, and a trend of notable appreciation of the shekel began. This trend continued until the end of the reviewed half year, so that at its end, the shekel was appreciated compared to the level at its beginning.

 

Fiscal policy: Against the background of the war, the deficit in the government budget increased in 2023, reaching 4.2 percent of GDP, compared to a surplus of 0.6 percent of GDP in 2022. The deficit in the updated 2024 budget is expected to be 6.6 percent of GDP, and the debt to GDP ratio is expected to increase to 66 percent at the end of 2024, from 60 percent of GDP just before the war. The war’s costs on the defense and civilian expenditures side as well as the loss of revenues are estimated by the Research Department to be more than NIS 200 billion. On January 15, the government approved the updated government budget for 2024, which includes budget adjustments of NIS 17 billion for 2024 and 2025. However, the marked increase expected in expenditures, even after the adjustments, is liable to create inflation pressures in the short-medium term commitment to maintain price stability.

 

Financial stability: Equity indices in Israel increased in the third quarter of 2023, and thus were notable compared to the global trend. However, equity indices in Israel since the beginning of 2023 have been characterized by significant underperformance compared to indices worldwide. The considerable uncertainty in the first days of the war were reflected in sharp declines in prices of financial assets—stocks, corporate bonds, and government bonds—with increasing volatility of prices and a decline in liquidity levels. Most of the impacts dissipated after a short time, but market volatility remained high, as did the country’s risk premium. In view of the war in Israel, two of leading ratings agencies announced that they are placing Israel’s credit rating on a “negative outlook” and rating agency S&P decided to downgrade its credit rating outlook. During the reviewed half year, the credit balance increased slightly only for large and medium sized companies—further to the trend that began before the eruption of the war. After the war broke out, the Monetary Committee announced a monetary program focused on easing the terms of credit for small and micro businesses that had been adversely impacted by the war. With regard to the financial risks, the construction and real estate industry should be emphasized in particular, as even just before the war it was dealing with rising financing costs and a marked decrease in demand, alongside a moderate trend of price declines. With the eruption of the war, most construction sides closed due to the absence of Palestinian employees. Credit to the construction and real estate industry makes up appoint 38 percent of total bank credit and about 44 percent of the tradable corporate bond balance, so the construction companies’ ability to deal with the high financing costs alongside a decline in their revenue has an important impact on the performance of the financial system.

 

The housing market: During the half year, the increase in home prices halted, and a decline was seen. For the first time since 2018, the annual rate of increase of home prices was negative, at -1.3 percent. This is in contrast to the parallel figure of 9.8 percent at the end of the previous half year, and the rate of increase that reached a peak of 20 percent in September 2022. The halting of the price increase was accompanied by a sharp decline in mortgage volume and in the number of transactions. A similar trend can be seen in the development of rent prices – declines of 0.3 percent in October and of 0.8 percent in November were seen, for the first time in two and a half years. However, in contrast to home prices, the annual rate of increase at the end of the half year is still positive, but it moderated to 3.9 percent.

 

The global economy: In the second half of 2023, central banks slowed the pace of interest rate increases, and currently it appears that the interest rate increase cycle has reached its end—among other things in view of the continued moderation in inflation. The interest rate path expected by the markets declined markedly, and according to it, several interest rate reductions are expected during the course of 2024. However, even at the end of the reviewed half year, inflation levels in major blocs remained higher than major central banks’ targets, mainly because of the continued demand pressures in the services industries. The economic activity in major economies moderated, and in the background, there was continued weakness in the global manufacturing sector and in world trade. Major equity indices worldwide increased sharply, led by big technology companies. With that, the trading was volatile against the background of large lack of uncertainty, deriving from, among other things, the continuation of tight monetary policy and concern of its ramifications on real and financial activity.

 

The Research Department staff forecast: The Research Department published three forecasts during the reviewed period, alongside the interest rate announcements in July 2023, October 2023, and January 2024. In addition, another forecast, unscheduled, was published in November 2023, with some clarification of the uncertainty that prevailed when the October forecast was being compiled, which was only about 2 weeks after the eruption of the war. Based on the forecast published in the beginning of January, GDP is expected to grow by 2 percent in each of 2023 and 2024, as in the November forecast, and by 5 percent in 2025—so that the output gap is expected to close in that year. In 2024 and 2025, the broad unemployment rate among the prime working ages (25–64) is expected to be, on average, 5.3 percent in 2024 and 3.2 percent in 2025. The annual inflation rate over the 4 quarters of 2024 is expected to be 2.4 percent, and during 2025 to be 2 percent.