To January 2016 Interest Rate
To Staff Forecast
As we announced, today the Monetary Committee decided to keep the interest rate unchanged, at 0.1 percent. This decision was reached after taking into account a range of considerations resulting from the data presented to the Committee, and in view of the monetary policy targets.
The three months that passed since we met here at the previous press briefing were replete with events, economic and otherwise, in Israel and abroad. Geopolitical and security-related developments, in Europe and in Israel, increased the uncertainty regarding projected economic developments. In contrast, the lack of clarity that prevailed around the monetary policy of major central banks was somewhat reduced, after the Federal Reserve and the ECB signaled more clearly their path of monetary policy in the near future. The first increase in years of the US federal funds rate, while at the same time the enhanced monetary accommodation in Europe, create a new era, in terms of Israel’s economy—a divergence of monetary policy in the two major blocs from the economy’s perspective. Israel’s economy is in a relatively unique position, as it is not especially coordinated with one of the two blocs as opposed to the other, and therefore the policy divergence will have consequences, on which I will elaborate further on. The developments in recent months led to the Monetary Committee being able to assess with relatively high probability that monetary policy in Israel will remain accommodative for a considerable period, and therefore, for the first time, this assessment was communicated to the public within the framework of the monthly policy announcement.
During the course of the fourth quarter, the decline in the short-term inflation environment continued, and inflation as measured over the preceding 12 months is -0.9 percent. The occurrences with one-off characteristics, which we described at the previous briefing and which have taken place since then, reduced actual inflation, as expected. The decline in energy prices and the administrative price reductions, such as reduced VAT rates, electricity rates, and television fee, reduced the level of prices, in our assessment, by about 1.7 percent in the past year. Excluding these effects, the inflation rate was 0.8 percent, which is also below the target range. It is important to note that monetary policy cannot, and should not, offset price declines that have already occurred. Recently, the decline in energy prices continued, and if it persists, it is expected to continue serving to reduce the CPI in coming months as well. Additional price declines initiated by the government, such as with regard to water, public transportation, and vehicle insurance, will also act to moderate inflation in the coming months. These factors are reflected in the further decline in recent weeks in short-term inflation expectations. The Committee assesses that the accommodative policy will act to return the inflation rate to within the target range, in the period of time defined by law, after the effect of the factors that I mentioned dissipates. In the past year, there was an acceleration in the rate of increase of nominal wages in the business sector, and this is expected to be a factor supporting the return of inflation to within the target range. Medium and long term inflation expectations show that a similar assessment prevails in financial markets—that over time, monetary policy will lead to attaining the inflation target.
During the course of the fourth quarter, the picture of real economic activity became somewhat clearer. After a marked moderation in second quarter growth, third quarter data reflected a return of the growth rate to its environment of recent years, of about 2.5 percent, though there was no compensation for the low growth of the previous quarter. This is moderate growth, but reasonable in view of the global economic situation. Current indicators support the assessment that this rate was maintained during the course of the fourth quarter as well, despite the outbreak of the wave of violence, the impact of which on aggregate activity has been moderate to date, and is reflected mainly in another adverse impact on the tourism industry. Private consumption, supported by the accommodative policy, continues to lead growth. Growth has not been seen in exports, over time, nor in investment. It is important that in addition to the support provided by monetary policy, long-term policy measures will also be adopted in order to stimulate exports and investment. Despite a slight decline in very recent data on the employment rate, the labor market continues to provide positive data of low unemployment, high levels of participation and employment, and increases in wages.
Recently, there have been several contrasting trends in the global economy. In advanced economies, moderate recovery continues, supported by accommodative policy. In emerging markets, in contrast, a slowdown is apparent. China’s economy is undergoing a structural change, which is reflected in some slowdown in its growth rate. Other emerging markets are suffering from structural difficulties, from the decline in commodity prices, and in some of them the risks to growth and to stability are becoming notable. In addition, as noted, a trend of divergence began in the monetary policy of the large blocs. In the US, the Fed became convinced that the recovery is robust enough to begin a gradual process of raising interest rates, while in Europe the ECB was of the opinion that achieving the policy targets needed enhanced monetary accommodation. The effects of the contrasting directions of policy on Israel’s economy will need to be evaluated over time. The exposure of the economy to the two blocs in terms of trade volume is similar, and while the federal funds rate increase and the entrenchment of growth in the US will help exporters to that bloc, the accommodative policy in Europe is expected to weigh on exporters to the euro bloc. The monetary interest rate is uniform, and is unable to support manufacturers exposed to one bloc in a different manner than those exposed to the other bloc. The conduct of monetary policy will need to take into account the range of effects of developments in the major economies on exchange rates, inflation, real activity, and financial markets.
The effective exchange rate has appreciated by 2.1 percent since the previous briefing, and its level is overvalued relative to the level that, based on various assessments, reflects equilibrium in line with fundamental forces. It is difficult to forecast the effects of the expected trends in monetary policy worldwide on cross rates and on the effective rate. Bank of Israel policy, as part of which $2.1 billion were purchased in the fourth quarter, will continue to help achieve policy targets in this regard.
Interest rate policy supports the achieving of the Bank of Israel’s objectives, and takes into account financial stability in general, and the housing market in particular. The rate of mortgages extended remains very elevated, and the Bank of Israel continues to closely monitor the development of risks in this area. Although the increase in prices continues, in recent months the growth in construction volume has continued, and this is an important development that can contribute to reducing the pressure on home prices. It is important that the government persists in its efforts to increase the stock of land available for construction and the supply of housing available for residence. Only steps in this area will be able to lead to a solution to the basic problem in the housing market.
Today, the Research Department published its updated forecast. It should be remembered that it is a contingent forecast based on assumptions regarding exogenous variables. The further decline in energy prices, the moderation of the inflation environment, the most recent effects of the slowdown in activity in the second half of 2015, and the downward revision in the forecast of world trade, led to the forecast reflecting more moderate assessments of activity, inflation, and the path of the interest rate compared with the previous forecast. Thus, the forecast for GDP growth in 2016 was lowered from 3.3 percent in the previous forecast to 2.8 percent in the current forecast; the return of inflation to within the target range is expected, according to the revised forecast, to occur only in the beginning of 2017, and as a result of these, the path of the interest rate according to the current forecast is lower than it was under the previous forecast. I recommend looking not only at the forecast itself, but also at the fan charts presented in the document in which it was published – these reflect uncertainty about any future forecast.
In conclusion, we presented the main developments in view of which monetary policy was conducted during the fourth quarter. In the near term, the main challenge to policy will be to assess the effect of policy measures in opposing directions expected to be adopted in the US and in Europe on the variables in Israel’s economy—the exchange rate, inflation, real activity, and financial markets. While the uncertainty regarding policy measures of the central banks has been reduced, uncertainty still remains regarding the effect on economic variables in the Israeli economy. The policy response in Israel will not be automatic, but will be examined in light of the effect, as noted, on the Israeli economy. Likewise, the Committee will continue to examine the extent to which the various processes that impact mainly on inflation reflect occurrences of a one-off character, which do not justify a response by a forward-looking policy.
At this point, the low inflation environment, moderate rate of growth, continued highly accommodative policy worldwide (including in the US), and the risks to achieving policy objectives, justify, in the Monetary Committee’s assessment, the continued accommodative policy over time. The Bank of Israel will continue to closely follow developments in the global and Israeli economies, and the Monetary Committee will be able to operate all the policy tools available to it, at any time, should there be a need.