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Monetary Policy Report 2011, January-March
Letter of the Governor accompanying the Monetary Policy Report for January–March 2011
Bank of Israel Jerusalem
May 2011
This Monetary Policy Report,* covering the first quarter of 2011, 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.
The Consumer Price Index (CPI) increased 0.7 percent in the first quarter of 2011, significantly above the midpoint of the inflation target range, seasonally adjusted. The steep rise of the CPI was influenced by domestic factors – housing prices and fruit and vegetable prices, and by external factors – global prices of energy and commodities.
The development of prices in the past twelve months, which rose 4.3 percent, points to a significant acceleration in the rate of inflation in the first quarter of 2011. The trend of rising housing prices, which began in the beginning of 2008, was reflected in the latest data published during the first quarter, and their increase over the preceding twelve months reached 16.1 percent. These developments increase the concern that the trend of rising housing prices – if it continues – could jeopardize the financial and real stability of the economy.
Economic activity in the first quarter of 2011 continued to expand strongly, a continuation of the fast expansion in 2010, which included all the components of aggregate demand, especially private consumption. The expanding activity continues to be reflected in the labor market: the number of employed persons rose in the last quarter of 2010 at a notable rate, while the unemployment rate remained unchanged. Salary levels in the economy began to rise moderately during the course of the second half of 2010, in contrast to the falling trend which characterized them in recent years.
The economic environment in Israel is reflected in the capital market: although the prices of financial assets hardly rose in the first quarter of the year, they still reached a record level during its course, higher than their average levels before the financial crisis. It also appears that the pace of expansion of economic activity in Israel continues at a high level; according to Bank of Israel estimates, GDP growth in 2011 will reach 4.5 percent, primarily due to an expansion of domestic demand at a pace that could pressure prices upward over the course of 2011.
Emerging market economic activity is expected to grow in the next two years at a high rate, while developed economies are expected to show positive growth, but at a relatively low rate. Better than expected macroeconomic figures were reported recently in the US, which point to a noticeable improvement in activity, specifically a drop in unemployment.
The European Central Bank raised its interest rate at the beginning of April, for the first time since the crisis, but the notice accompanying the interest rate decision left much uncertainty about future hikes. In the US, while there is still no clear intention to raise the interest rate, and expectations are that it will remain at its low level until the end of the year at least, assessments are growing of an impending end of quantitative easing, as scheduled.
Israeli monetary policy was adjusted to the quick changes in economic activity and the local inflation environment. With the worsening of the crisis in the fourth quarter of 2008 and the first quarter of 2009, the Bank of Israel adopted a very expansionary monetary policy, and continued it through 2009 and 2010 as well, with a gradual cutting of the extent of expansion, in line with developments in the economic environment. In the quarter surveyed, with the acceleration in the pace of inflation and growth, fueled primarily by demand, the Bank of Israel quickened the pace of interest rate increases, and thus markedly cut the extent of the expansion: the interest rate for February and March was raised by 25 basis points each time, and in April it was raised by half a percentage point, above forecasts by the capital market and forecasters.
Balance of payments figures show that capital imported by foreigners into Israel in the quarter surveyed continued to be focused in the purchase of makam (short-term debt issued by the Bank of Israel) and in deposits with local banks, rather than direct investment or purchase of shares. The balance of makam held by nonresidents reached $12.5 billion, more than a third of the total stock of makam. The implication is that this capital inflow, which affects the exchange rate, is motivated by short term considerations. In order to reduce the influence of these short-term inflows on the exchange rate, the Bank of Israel intervened in the market and bought foreign currency. In addition, the Bank of Israel imposed in January 2011 a reporting obligation on Israeli residents on their transactions in foreign currency derivatives, and on nonresidents on their transactions in foreign currency derivatives and in makam. The Bank also imposed a reserve requirement on the banks for foreign currency derivative transactions with nonresidents.
The Bank of Israel expects that the year over year rate of inflation in twelve months will be slightly above the upper limit of the inflation target range, accompanied by a gradual process of raising the interest rate, and the rate of inflation will settle within the target range in the second half of 2012. The risks of deviation above or below are balanced. This estimate is based on a continued rise in food and energy prices and increasing demand, which are factors contributing to a higher inflation rate, countered by the rises in the interest rate by the Bank of Israel during the quarter surveyed, which totaled one percentage point, on – as necessary – further rises in the interest rate over the course of the coming year, and on the relative slowness of the global economic recovery, especially in developed markets. As a result there is an increasing widening in interest rate gaps which lead to stronger appreciation pressures.
The Bank of Israel will continue to reduce the extent of monetary expansion, which it has undertaken since the beginning of the financial crisis, in order to keep inflation within the target range, by supporting real activity and maintaining financial stability. The path of the interest rate is not fixed, but rather will be determined in accordance with the inflation environment, economic conditions in Israel and abroad, expectations of interest rate hikes by central banks in leading economies, and taking into account developments in the exchange rate of the shekel. The monthly decisions on the rate of monetary interest, and on intervention in the foreign currency market and its extent, will be made based on developments in those areas.


Stanley Fischer

Governor, Bank of Israel
Summary*
  Inflation: The CPI rose by 0.7 percent in the first quarter of 2011 (the quarter reviewed), and it increased 1.5 percent on a seasonally adjusted basis. Major reasons for the rise in the index were housing prices (reflecting primarily rents), food, and energy prices. The rate of inflation over the previous twelve months exceeded the upper limit of the inflation target range, and in March the figure was 4.3 percent. Inflation expectations for the next twelve months reached 3.7 percent on average in March, and long term expectations were at the upper level of the inflation target range. In the past year, there was a rise in the inflation environment, as demand rose and the economy grew. Home prices rose 16.1 percent over the course of the previous twelve months.
  The global economic environment: Developed markets continued their process of recovery from the global crisis, even if at a slow pace, while emerging markets are growing at a fast pace. The International Monetary Fund (IMF) forecasts that in 2011 developed markets will grow 2.4 percent and emerging markets will grow 6.5 percent. Over the course of the first quarter, prices of energy and commodities rose, which have boosted inflation rates around the world. In 2011, inflation is expected to be 2.2 percent in developed markets, and 6.9 percent in emerging markets. Interest rates in the US are only expected to rise in about another year, while Europe began raising rates in April, in line with market expectations.
  Real activity in Israel: Economic activity, which was strong throughout 2010, accelerated in the fourth quarter of 2010 and included all components of aggregate demand, but relied primarily on domestic demand. In the fourth quarter of 2010, Israel’s GDP grew by 7.8 percent (in annual terms, seasonally adjusted). Indicators of real economic activity in the first quarter point to continued growth at an impressive rate, its reflection in the labor market, and a boost in exports, as well as continued expansion of private consumption, even if at a more moderate pace than that of 2010.
  The exchange rate: Exchange rate movement was not uniform throughout the quarter. In January, the nominal effective exchange rate reflected shekel depreciation of 5.3 percent, and offset the sharp appreciation that preceded it. The depreciation was accompanied by a rise in the implied volatility in shekel-dollar options, against the background of geopolitical instability in various Arab countries and moves by the Bank of Israel in the foreign currency market. Later in the quarter, the nominal effective exchange rate returned to the level of the second half of 2010, and the standard deviation fell. With the interest rate rise for April, announced at the end of the first quarter, shekel appreciation resumed.
  The financial markets: The financial markets: Share price rises in Israel slowed in the quarter reviewed, in line with the trends in global stock markets. The Tel Aviv 100 Index fell 2.4 percent (average level of March compared with average level of December 2010). The change in trend came from, among other things, the growing uncertainty of geo-political developments in the Middle East, rising energy prices, and trends in world markets. Nominal and real yield curves of government bonds rose over the course of the quarter, pointing to the establishment of the growth, but also to rising inflation expectations. There was also a continued growth trend of new mortgages.
  Monetary policy: In the first quarter of 2011, the Bank of Israel accelerated the pace of interest rate increases. For each of the months of February and March, the interest rate was increased 0.25 percentage points, and for April the interest rate was raised 0.50 percentage points, to a level of 3 percent. The rise in inflation expectations for all time frames, actual inflation surpassing the target range, the quick growth of real local activity, and the continued rise of home prices, all supported the boosting of the monetary interest rate in order to bring inflation within the target range, and to protect financial stability and strong economic growth. At the same time, the Bank of Israel continued to operate in the foreign currency market in order to moderate the pressures for strengthening of the shekel. These activities included, besides buying foreign currency, the imposing of a liquidity requirement of 10 percent on banks for derivative transactions in foreign currency vis-א-vis nonresidents, and announcing the imposition of a reporting obligation on various transactions. While in the quarter there was a step away from monetary expansion, when taking economic conditions into account the monetary policy is still expansionary. In April, after the end of the quarter surveyed, the Bank of Israel instructed banks to limit the variable interest rate component of a mortgage to one third of the total loan granted to the borrower.
  The Bank of Israel Research Department forecast: The Research Department assessment is that inflation over the next twelve months will be 3.2 percent, slightly above the upper limit of the inflation target range. This is primarily because of the recent rises of commodity and energy prices, but is also because of the continuing rise in housing prices (reflecting rental contracts) and widening demand. At the same time, the economy is expected to continue to grow over the next two years, at strong rates of 4.5 percent in 2011 and 4 percent in 2012. In light of these expectations, it is expected that the interest rate will be raised gradually to about 4.4 percent in one year, and that during the second half of 2012 inflation will settle within the target price stability 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 on page 11 in the Bank of Israel Inflation Report No. 17, July-December 2005.)
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