Abstract
This document presents the forecast of macroeconomic developments compiled by the Bank of Israel Research Department in September 2016. The forecast was presented to the Monetary Committee on September 25, 2016, during its meeting prior to the decision on the Bank of Israel interest rate for October 2016. According to the staff forecast, gross domestic product (GDP) is projected to increase by 2.8 percent in 2016 and by 3.1 percent in 2017. The rate of inflation over the next year (ending in the third quarter of 2017) is expected to be 1.0 percent. The Bank of Israel interest rate is expected to remain at its current level of 0.1 percent during the coming year, and to begin rising at the end of 2017.
 
 
Forecast
The Bank of Israel Research Department compiles a staff forecast of macroeconomic developments on a quarterly basis. The staff forecast is based on several models, various data sources, and assessments based on economists' judgment.[1] The Bank's medium scale DSGE (Dynamic Stochastic General Equilibrium) model developed in the Research Department—a structural model based on microeconomic foundations—plays a primary role in formulating the macroeconomic forecast.[2] The model provides a framework for analyzing the forces which have an effect on the economy, and allows the integration of information from various sources into a macroeconomic forecast for real and nominal variables, with an internally consistent "economic story".
 
 
a.      The global environment
Our current assessments of expected developments in the global economy are based mainly on projections by international institutions (the International Monetary Fund and the OECD) and by foreign investment houses. These institutions revised their growth forecasts for advanced economies slightly downward following the referendum that led to the British decision to leave the European Union (Brexit). The revised forecasts are quite similar to our assumptions in the previous forecast.  Therefore, our assumptions remain unchanged—growth of 1.7 percent in the advanced economies in each of the years 2016 and 2017.  In terms of world trade, the IMF’s revised forecast in July lowered the projected growth of imports to the advanced economies in 2016.  Accordingly, we reduced our forecast of imports to advanced economies in 2016, and currently assess that they will increase by 2.6 percent, compared with 3.1 percent in the previous forecast. For 2017, we assess that these imports will increase by 3.9 percent, compared with 3.7 percent in our previous forecast. The forecast path of central bank interest rates, based on futures contract prices, declined slightly after the Brexit decision, and subsequently increased slightly. This path reflects the markets’ assessment that the US federal funds rate will be raised at a very moderate pace, and that interest rates in the Eurozone, UK, and Japan will remain at their current level over at least the next two years.
 
The average price of oil in the third quarter of the year remained close to its level in the previous quarter ($47 per barrel for Brent Sea Crude), and our assessment is that it will continue to remain at this level.  Global food prices declined in recent months, and their average level during the third quarter was about 10 percent lower than in the previous quarter.[3]  Our assessment is that this decline will be halted, and food prices will remain at their current level.
 
Against the background of these considerations, and similar to the revised IMF forecast, our assessment is that inflation in the advanced economies will increase gradually, to a total of 0.7 percent in 2016 and 1.6 percent in 2017.
 
b.      Real activity in Israel
 
Table 1
Economic Indicators
Research Department Staff Forecast for 2016 to 2017
(rates of change, percent, unless stated otherwise)
 
Data for
Bank of Israel forecast
Bank of Israel forecast
 
2015
2016
2017
GDP
2.5
2.8
3.1
Civilian imports (excluding diamonds, ships, and aircraft)
1.4
7.5
8.4
Private consumption
4.3
5.9
3.7
Fixed capital formation (excluding ships and aircraft)
0.0
5.8
6.3
Public sector consumption (excluding defense imports)
4.0
3.4
3.6
Exports (excluding diamonds and start-ups)
-2.7
1.0
3.9
Unemployment ratea
5.2
4.9
4.8
Inflation rateb
-0.9
-0.2
1.1
Bank of Israel interest ratec
0.10
0.10
0.25
a) Annual average.
b) Average CPI reading in the final quarter of the year compared with the final-quarter average in the previous year.
c) End of the year.
Source: Bank of Israel.
 
GDP is expected to grow by 2.8 percent in 2016 (Table 1). The higher rate of growth relative to the previous forecast (2.4 percent) is due to growth in the second quarter of 2016 being higher than we assessed when the previous forecast was compiled, and due to the upward revision of growth data for the first quarter. According to the data, GDP growth was reflected in all uses.  In particular, private consumption increased at an annual rate of 10.0 percent in the second quarter, further to high rates in the previous quarters.  Some of the increase in consumption was a result of an unusual jump in the consumption of transport vehicles[4], but current consumption also grew at a rapid rate, supported by the low interest rate level and the high employment level.  Exports and fixed capital formation also increased at a higher rate than expected during the second quarter, and the growth rate for the first quarter was revised upward.  As a result, forecast growth for these components in 2016 was revised upward.
 
The growth forecast for 2017 was increased slightly, to 3.1 percent (compared with 2.9 percent in the previous forecast). This revision is mainly a result of an increase in the forecast growth of two uses—private consumption, and public consumption.  Due to the high level of private consumption and following a long period of rapid growth relative to other uses and to GDP[5], our assessment is that growth of private consumption will moderate in 2017, to 3.7 percent (compared with 2.8 percent in the previous forecast).  The forecast for public consumption was revised in accordance with the budget for 2017 and 2018.  Investment in 2017 is expected to grow by 6.3 percent, due to investment by a large company (which will be almost entirely attributed to the import of machines and equipment).  Exports are expected to grow in 2017 by 3.9 percent, partly as a result of increased exports of electronic components following the aforementioned investment, and supported by a recovery in world trade.  Finally, the growth of imports is expected to accelerate in 2017 to 8.4 percent, largely as a result of the aforementioned investment.
 
c.       Inflation and interest rate estimates
In our assessment, inflation in the four quarters ending in the third quarter of 2017 is expected to be 1.0 percent.[6] This forecast reflects the assessment that the trend of some of the factors in the moderation of inflation in the past two years will change—the decline in commodity prices is expected to be mostly halted, global inflation is expected to increase gradually in the coming year, and the prices of imported goods are therefore expected to increase more rapidly than in the past two years.  Furthermore, our assessment is that as the economy draws near to full employment, the forces for an increase in domestic inflation from the wages side will strengthen.  The forecast is 0.1 percent lower than the previous forecast for inflation during the parallel period (Figure 1), due to the decline in food prices and due to the appreciation of the effective exchange rate of the shekel since the previous forecast.
 
Table 2
Forecasts for inflation rate and interest rate for the coming year
(percent)
 
Bank of Israel Research Department
Capital marketsa
Private forecastersb
Inflation ratec
1.0
0.5
0.7
(range of forecasts)
 
 
(0.1–1.2)
Interest rated
0.1
0.1
0.10
(range of forecasts)
 
 
(0.0–0.25)
a) Daily average for the month of September (up to September 21). Seasonally adjusted inflation expectations.
b) Inflation and interest rate forecasts are those published after the publication of the CPI reading for August.
c) Inflation rate over the next year (Research Department: in the next four quarters).
d) The interest rate in 1 year (Research Department: the interest rate in the third quarter of 2017). Capital markets forecast derived from Telbor rates.
Source: Bank of Israel.
 
According to the Research Department’s assessment, the Bank of Israel interest rate is expected to be 0.1 percent until the third quarter of 2017, and to start increasing thereafter. This path reflects a balance between the need to bring inflation to its target and to support real activity, and the need to maintain financial stability. This path of the interest rate also takes into account the expected paths of interest rates in the US and in other economies—which are expected to remain low for a long time. Figure 2 shows that the expected path of the interest rate in 2017 is the same as what was published in the previous forecast.
 
Table 2 shows that the forecast compiled by the Research Department regarding the interest rate in the coming year is similar to expectations derived from the capital markets and projections of professional forecasters. However, with regard to inflation, the Research Department’s forecast is higher than that of the professional forecasters, on average, and is higher than expectations derived from the capital market.
 
d.      Balance of risks in the forecast
This forecast is contingent on assumptions related to the global environment and to domestic background conditions. Developments different from those assumptions may lead to developments in the domestic economy that are different from those in the forecast.  There has been uncertainty in recent years in relation to the pace of the global recovery from the economic crisis.  There has been added uncertainty in recent months due to the UK decision to leave the European Union.  This uncertainty concerns both the measures to be taken by the UK and the EU as part of the Brexit process and the expected implications of those measures.  IMF economists noted in their July survey that in view of the Brexit decision, there is greater likelihood of lower scenarios in relation to their base forecast for the global economy.
 
Figures 1 to 3 present fan charts around the inflation rate, interest rate and GDP growth forecasts. (The broken line represents the baseline forecast from June.) The width of the fan is derived from the estimated distributions of the shocks in the Research Department's DSGE model.
 
Figure 1
Actual Inflation and Fan Chart of Expected Inflation
(cumulative increase in prices in previous four quarters)

sf1.png

 

Figure 2
Actual Bank of Israel Interest Rate and Fan Chart of Expected Interest Rate

sf2.png

Figure 3
Actual GDP Growth Rate in the Past Four Quarters and Fan Chart of Expected Growth Rate
(total GDP over the past four quarters relative to GDP in the preceding four quarters)

sf3.png

 

 

 

 

[1] An explanation of the staff macroeconomic forecast, and an overview of the models on which it is based, can be found in Inflation Report 31 for the second quarter of 2010, section 3-C.
[2] A Discussion Paper on the model is available on the Bank of Israel website, under the title: “MOISE: A DSGE Model for the Israeli Economy,” Discussion Paper No. 2012.06.
[3]  According to the Bloomberg Food Prices Index.
[4] In January 2017, new tax regulations relative to vehicles with high air pollution are expected to come into effect, and it is possible that some of the unusual level of vehicle consumption is due to purchases being brought forward as a result of these regulations.  There was a similar phenomenon in the investment item (with a very unusual increase in investment in passenger vehicles) and in imports.
[5] According to figures on consumption at fixed prices.
[6] In the four quarters ending in the last quarter of 2017, inflation is expected to be 1.1 percent (see Table 1).