To the Presentation of the Research Department' Staff Forecast
Central banks around the world consider ways to improve the communication between monetary policy makers and the financial markets, in particular, and the wider public, in general. The very low interest rate environment, and central banks using, and having used, unconventional policy tools, bolsters the need for that, and also makes the communication more challenging and complicated. We decided to begin holding these briefings, once every three months, in order to improve our dialogue with the public regarding the considerations that guide monetary policy—and I intentionally use the term dialogue, because the presence of the press in this room allows the public, through you, to ask questions.
As you know, the Monetary Committee decided today to leave the interest rate unchanged, after we reduced it at the end of February to the low level of 0.1 percent. Together with Bank of Israel activity in the foreign exchange market, monetary policy continues to be very accommodative. The accommodative policy acts to restore inflation to within the target range, and we see as well a convergence of expectations to around the target. I will expand on that soon. The expansionary policy supports economic activity as well, as we remain in an environment of rather moderate global growth.
In my remarks, I will refer to the main developments that we considered when reaching policy decisions in the past three months, including the inflation environment, assessments of economic activity and of the effect of the exchange rate and the global economy, and the connection between monetary policy and asset markets.
About a year ago, a decline in the inflation environment began to be seen. Against the background of the appreciation of the shekel and the decline in energy prices, there was a decline in actual inflation, reaching a low of negative 1 percent measured over the preceding 12 months. Later, short term inflation expectations from various sources also declined to below the lower bound of the inflation target range. The Monetary Committee is committed to the inflation target, and in light of that, the Committee reduced the interest rate to its current level. It is also important to note that the credibility of monetary policy remains robust, as seen in expectations for medium and longer terms remaining entrenched around the midpoint of the inflation target range. During the second quarter, which is what we are focusing on today, the inflation picture became clearer. The decrease in energy prices halted, and after the CPI declined by a cumulative 1.6 percent in January–February, in light of, among other things, one-off reductions in water and electricity prices, the CPI in its three most recent readings, for March through May, increased at a pace consistent with the inflation target, and the concern of an extended period of not meeting the target declined. The marked deprecation in the second half of 2014 also contributed to this. Currently, we are also seeing a gradual return of short term expectations to within the inflation target range.
After the considerable volatility in the rate of growth in the third and fourth quarters of 2014, against the background of the slowdown during Operation Protective Edge, and the subsequent recovery, we returned in the first quarter to a moderate growth rate of 2.1 percent, led by private consumption, which increased by 7.5 percent, and with a worrying virtual standstill in exports, which declined by 1.9 percent, and in investments, which declined by 8.1 percent. In contrast, labor market data continued to be positive, pointing to the stabilizing of unemployment at low levels, and the participation and employment rates at elevated levels. The trends in exports are especially worrying in view of the reduction of global growth forecasts by international institutions. The IMF also assessed that many countries are going through a type of structural change, following which global growth will be less based on trade—meaning, world trade will grow less than in the past. For small open economies, and certainly for Israel’s economy, this is not good news.
But why? Because exports were the economy’s growth driver in times of sustained robust growth, and as we have shown recently on several occasions, exports are also the productivity driver of the Israeli economy. Export industries are a source of quality employment, at suitable salaries, and in peripheral areas as well. The troubling facts are that after the recovery from the crisis, goods exports more or less have maintained a fixed level since 2011, and growth of services exports stopped around 2012. In this regard, I will note that based on various assessments, the current exchange rate is appreciated to some extent vis-à-vis estimates of the equilibrium exchange rate. These all are at the background of the Bank of Israel’s policy in the foreign exchange market. The process of the dollar strengthening worldwide was halted in recent months, and we saw volatility in cross rates, and thus also in the shekel-dollar and shekel-euro exchange rates during the past quarter. The important indicator in terms of the exchange rate’s effect on the economy is the effective exchange rate, which appreciated by 2.7 percent during the quarter.
There are two components to Bank of Israel policy in the foreign exchange market. In the past three months activity was quite intensive—the Bank purchased some $2 billion in the market, of which some $1.5 billion was through the program that is activated when there are extraordinary fluctuations in the exchange rate that are not in line with fundamental economic conditions. The remainder was within the program intended to offset the effect of natural gas production on the exchange rate. The foreign currency purchases acted to moderate the rate of appreciation, and thus supported activity, with an emphasis on exports and the rest of the tradable sector, as well as the return of inflation and inflation expectations to within the target range.
Exports are affected by, as noted, developments abroad as well, and the indicators we receive continue to point to moderate growth. Recent figures indicate some improvement in US data and support the assessment that the slowdown seen in the first quarter was temporary, deriving from transitory factors, and that the US economy is returning to a trend of improvement. In Europe as well there is a moderate trend of improvement and it appears that the ECB’s aggressive measures are bearing fruit. With that, developments in Greece clearly pose a significant risk, and if they have a negative effect on Europe’s economy it will be felt by us as well. A slowdown in China is also expected to have some impact on Israeli exports, and the central bank there is also adopting expansionary policy. In general, global monetary policy remains very accommodative; the question of when, and at what pace, the federal funds rate will be increased remains relevant, even after the Federal Reserve’s statement last week.
In addition to the positive effects of the interest rate on activity in general and on private consumption in particular, and on inflation, we are also aware, of course, that interest rate policy impacts on asset markets too, and in this regard we closely follow, primarily, the housing market. We are not the only ones who are monitoring this important market, because it of course has important aspects both in terms of economic activity and in terms of the cost of living and home purchase affordability. As we have noted on more than one occasion, the fundamental solution to the problem lies in a prolonged increase of supply, including in areas in high demand. We do in fact see an increase in construction volume in recent months, and the government has put finding a solution to the housing problem high on its list of priorities. The Bank of Israel monitors developments in housing primarily with regard to the risks deriving from it. Home prices are again increasing, even if the rate of price increases in the past year, 3.4 percent, is lower than what we’ve seen in the past, and the rate of new mortgages taken out increased and is very high. With that, the risk characteristics of mortgages continue to decline. Banking Supervision Department directives reduced the loan to value ratio and the payment to income ratio, and in addition we have seen in recent months an increase in the share of mortgages taken out at fixed interest rates, reaching 56 percent compared with 43 percent a year ago, in light of the very low environment reached by longer term interest rates. In the past month, there was relatively high volatility in government bond yields worldwide, which impacted on the Israeli market as well, and we saw an increase primarily in long term yields. This was a foreseeable development, even if it was relatively quite powerful, and it is still not clear if this is the beginning of a process or a short term fluctuation. In light of the increasing share of fixed rate mortgages that was noted, the increase in yields obviously impacts on mortgage interest rates in Israel.
As we have noted in recent months, the Bank of Israel examined the need to use various unconventional tools. But it is important to emphasize: such tools are utilized in unconventional circumstances. I reiterate that even without use of such tools, monetary policy at the current interest rate level, and which includes, as noted, foreign currency market intervention, is highly accommodative. In light of the expected path of inflation returning to within the target range and the stabilization of a moderate rate of growth, it appears that the probability that we will be required to use unconventional tools in the near future has declined. However, the economic world is one of unexpected shocks, and the well known expression—never say never—is still relevant. We continue to examine developments all the time, and to make decisions in accordance with economic data received and assessments that are formulated.
In conclusion, the accommodative monetary policy acted to return inflation to within the target range and to support growth and employment. We are cognizant of the risks deriving from the low interest rate environment. We acted to hedge some of them within the framework of macroprudential policy in the area of housing credit, and we have in fact seen that despite the increase in the pace of mortgages taken out, the risk characteristics of mortgages are lower. Ultimately, the interest rate environment is derived from economic developments in Israel, and these are impacted on by global developments, so that the interest rate cannot be disconnected for an extended time from the global interest rate environment. The beginning of the process of increasing the federal funds rate in the US, primarily if it will be a signal of recovery in economic activity, will be able to support a gradual return to a normal interest rate environment for us as well. However, the timing and the pace of interest rate changes in Israel will be determined by the Monetary Committee in accordance with developments in Israel’s economy, and data available to the Committee.
The staff forecast, which serves as an input to the Committee’s monetary discussions, will be presented by the Director of the Research Department, Prof. Nathan Sussman. It is important to note, right at the outset, that it is a forecast contingent on assumptions about exogenous developments, which reflects the independent assessments of the Research Department.