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The Bank of Israel’s Monetary Program for January 2004 The Bank of Israel today announced its monetary program for January 2004, according to which the interest rate will be reduced by 0.4 percentage points to 4.8 percent. This brings the cumulative reduction in the Bank of Israel’s interest rate since December 2002 to 4.3 percentage points. The continuation of the process of reducing the interest rate is made possible by the fact that one-year inflation expectations are slightly below the price-stability target of 1-3 percent, against the background of the actual reduction in the Consumer Price Index in the last twelve months, the continued moderate level of real economic activity, and the relative calm in the foreign currency, money, and capital markets. The cut in the interest rate serves to support the encouragement of economic growth and increase employment—short-term interest declined from 7.2 percent in December 2002 to 4.5 percent in December 2003—while maintaining price and financial stability. One-year inflation expectations derived from the capital market declined in December, and are currently slightly below the lower boundary of the target range (i.e., just below 1 percent), and expectations for the second year ahead are still within the target range. Private forecasters’ predictions of 12-month inflation are down slightly and are below the middle of the target range; some of the models developed by the Bank of Israel indicate that it is possible to attain the inflation target for the coming year and the following year while slowly continuing to reduce the interest rate. The changes in the composition of the public’s asset portfolio derive inter alia from the process of interest-rate reduction by the Bank of Israel. Most prominent among them this year is the rise in the proportion of shares in it due to the increase in their price, and this accounted for about two-thirds of the increase in the portfolio between the beginning of the year and October 2003. The decline in short- and long-term interest rates led to a rise in the value of tradable assets, and their proportion expanded relative to bank deposits. Furthermore, despite the marked reduction in the interest-rate differential between Israel and the rest of the world as a result of Israel’s interest-rate reduction process, there has been a gradual alignment between the share of local-currency and foreign-currency assets in the portfolio, alongside the continued sound functioning of the markets. The interest-rate policy is directed towards achieving price stability on an ongoing basis, and not necessarily for any particular calendar year. Any attempt to achieve the target of price stability by the end of 2003, following the fall in prices since the beginning of the year, would have required the rapid acceleration of inflation in the short term, alongside steep cuts in interest rates, which could have endangered financial stability, the process of economic recovery, and in the final analysis price stability itself. Accordingly, the Bank of Israel’s policy at all times is aimed at attaining price stability over a period of one and two years forward. In the last few months the decline in yields on government bonds has persisted, albeit at a slower rate: since the beginning of the year nominal yields (on 10-year bonds) have dropped by more than 4.5 percentage points to a level of about 7.0 percent, and real yields by more than 1.5 percentage points to a level of about 4.2 percent. The reduction in long-term interest on government bonds apparently indicates that the public considers that the budget deficit (which is relatively large and greater than in 2002) derives mainly from the temporary effect of the low level of economic activity in reducing the government’s tax revenues, and that it is to a lesser degree a structural deficit constituting a long-term problem. The approval of the government’s budget for 2004 and the avoidance of any departure from the budget framework is vital for maintaining the stability that has been attained. Adherence to this stance, and the determination to return to a declining government deficit and debt path, together with the reform of the labor market and the implementation of the plans for infrastructure investment, contribute to steering the economy back to a growth path. Departure from this path, in view of the large government debt, could lead to a rise in nominal and real yields, and hamper the process of economic recovery that has recently begun to emerge. The calm in the foreign currency market, expressed in the strengthening of the NIS relative to the dollar and its depreciation against the euro, reflects shifts in the international currency markets. Israel’s risk premium, as measured by the 5-year credit-default-swap (CDS) market, remained at 60 basis points in December, after the downward path evident since the first quarter of 2003. The calm in the market appears to be due to the US government loan guarantees and the credibility of macroeconomic policy in the eyes of the public. Nonresidents’ short-term capital inflow to Israel is affected among other things by changes in interest rates in other advanced and emerging economies (not only the US and Europe) to which international capital flows are directed. This can be seen from Table 3: the Bank of Israel’s interest rate is already slightly below the upper level of interest rates of central banks in the advanced economies (Australia and New Zealand—5 percent), only one percentage point higher than in the UK, and in the mid-range of central-bank interest rates in emerging markets and other developing economies. The Bank of Israel monitors developments in the markets and will continue to act to turn the inflation rate back to the price stability range while bolstering financial stability. Subject to these conditions, the Bank will continue to act to support the policy of fostering employment and bolstering economic activity.
Table 1: Interest Rates in Israel and the US
Table 2: The Bank of Israel Real Rate of Interest, the Yield on Treasury Bills and on Shahar Bonds, and the Real Yield on CPI-Indexed Government Bonds (monthly average, percent)
* Including two increases in the interest rate in the month. The Bank of Israel’s effective and real interest rates are calculated on the basis of monthly averages. aAnnounced interest rate in simple annual terms (excluding compound interest). bCalculated as the daily compound interest rate, based on the interbank rate (see explanation in BOI no. 2, p. 17). cThe real rate of interest is the effective rate of interest less inflation expectations derived from the capital market. dUp to June 2002 the yield on 10-year auctions. From July the average daily market yield.
Table 3: Central-Bank Interest Rates in Several Countries, December 2003
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The Bank of Israel's Monetary Program for January 2004
The Bank of Israel's Monetary Program for January 2004
29/12/2003