This document presents the forecast of macroeconomic developments
compiled by the Bank of Israel Research Department in December 2016. The
forecast was presented to the Monetary Committee on December 25, 2016, during
its meeting prior to the decision on the Bank of Israel interest rate for January
2017. According to the staff forecast, gross domestic product (GDP) is
projected to increase by 3.2 percent in 2017 and by 3.1 percent in 2018. The rate
of inflation over the next year (ending in the fourth 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 in the first three quarters of 2017,
and to increase gradually from the fourth quarter of 2017.



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 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".



The global environment

Our 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 forecasts for growth in advanced economies and for world trade slightly
downward. Our forecasts are for growth in advanced economies of 1.7 percent in
2017 and 1.8 percent in 2018. As for the world trade, in its recent Economic
Outlook from November, the OECD reduced the expected growth of trade to 2.9 percent
in 2017, and forecast 3.2 percent in 2018. The revised forecasts indicate that the
international institutions expect that compared with the past, global growth in
coming years will be based less on world trade and more on domestic demand,
because, among other things, recent political developments in the US and the
UK, reflect a tendency worldwide toward more isolationist economic policy.


Based on assessments derived from the capital market (assessments based
on interest rate futures contract prices), the forecast path of the US federal
funds rate rose sharply after the US elections. There was a further moderate
increase in December, after the Federal Reserve’s decision to increase the
federal funds target rate. According to these assessments, the federal funds
rate is expected to increase to around 1.2 percent at the end of 2017 and to
around 1.6 percent at the end of 2018. (The median assessment of the members of
the Federal Open Market Committee is that the interest rate will increase more
rapidly—to 1.4 percent at the end of 2017 and 2.1 percent at the end of 2018.)
In contrast, the interest rate on deposits in Europe is expected to remain
negative at -0.3 percent at the end of 2017 and -0.2 percent at the end of 2018,
and this policy will be supported by an asset purchase plan, which according to
the most recent ECB announcement was extended until the end of 2017.


At the end of November, OPEC announced an agreement to reduce production
quotas, in which Russia was also expected to take part. Following the
announcement the price of a barrel of Brent crude oil increased to around $54.
The forecast is based on the assumption that the price of oil will remain at
this level (compared with $47 per barrel that we assumed in the previous
quarter). Nonenergy commodity prices also increased in recent months, and
contributed to an upward revision in international institutions’ global inflation
forecasts. In accordance with those forecasts, we assess that inflation in
advanced economies will be 1.8 percent in 2017 (compared with 1.6 percent that
we assumed in the previous forecast) and 2 percent in 2018.


Real activity in Israel

GDP is expected to grow by 3.5 percent in 2016 (Table 1). The increase
relative to the previous forecast (2.8 percent) derives from National Accounts
data for the first half of 2016 being revised upward, and third quarter growth being
higher than we assessed when compiling the previous forecast. Based on the
data, the increase in GDP was seen mainly in domestic uses: private consumption
and investments, which are supported by the low interest rate and the high rate
of employment, as well as public consumption. Part of the growth in GDP reflects
an atypical jump in imports of transportation vehicles for personal use and
investment.[3],[4] Net of this
factor, we assess that GDP growth in 2016 will be about 3 percent.


The forecast for growth is 3.2 percent in 2017 and 3.1 percent in
The expected development of GDP reflects a gradual transition to
growth based less on domestic uses and more on exports. Thus, the growth rate of
private consumption is expected to moderate gradually, after a long period in
which it was relatively rapid compared with the rate of growth of other uses
and the GDP growth rate. In contrast, exports are expected to grow by a more
rapid pace than in the past, in light of international institutions’ forecasts
for gradual recovery of world trade. Compared with the previous forecast, the
composition of uses is expected to change more slowly. This is in light of data
indicating continued strength of private consumption, while in contrast, international
institutions’ forecasts reflect a slower recovery of world trade, compared with
the forecast when compiling the previous forecast.

Table 1

Economic Indicators

Research Department Staff Forecast for 2016 to 2018

(rates of change, percent, unless
stated otherwise. Previous forecast in parentheses.)


Estimate for

Bank of Israel

Bank of Israel









Civilian imports (excluding diamonds, ships, and aircraft)




Private consumption




Fixed capital
formation (excluding ships and aircraft)




Public sector consumption
(excluding defense imports)




Exports (excluding
diamonds and start-ups)




Unemployment ratea




Inflation rateb




Bank of Israel
interest ratec




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.


Inflation and interest rate

In our assessment, the inflation rate in 2017 will be 1.0 percent and
in 2018 it will be 1.5 percent.
The inflation forecast reflects the
assessment that prices of domestic products and of imported products will
develop differently. Prices of imported products are expected to increase at a
higher rate than that of the past two years, as inflation expectations
worldwide increased against the background of the US election results and the
increase in commodity prices. In contrast, the low inflation in the final quarter
of 2016 strengthened the assessment that there are forces acting to moderate
domestic inflation—including enhanced competition and government measures to reduce
the cost of living—and in our assessment they are likely to continue moderating
domestic inflation over the next two years as well; in addition, convergence
toward full employment and the wage increases have not, to date, created pressure
for increasing domestic inflation. We expect that wages will continue to increase,
against the background of labor market resilience, and it is plausible that
this will act to increase inflation.



Table 2

Forecasts for inflation rate and interest rate for the coming



Bank of Israel Research Department

Capital marketsa

Private forecastersb

Inflation ratec




(range of forecasts)




Interest rated




(range of forecasts)




a) Daily average for the month of December
(up to the 21st). Seasonally adjusted inflation expectations.

b) Inflation and interest rate forecasts are
those published after the publication of the CPI reading for November.

c) Inflation rate over the next year (Research
Department: in the four quarters ending in the fourth quarter of 2017).

d) The interest rate in one year (Research
Department: the interest rate in the fourth 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.
The interest rate is expected to remain at
its current level in the coming months, in order to support the return of
inflation to within the target range and economic growth. The interest rate is
expected to begin to rise in the final quarter of the year, to 0.25 percent,
against the background of a gradual increase in the inflation rate and
continued growth of GDP at a rate of around 3 percent. We expect an additional
increase in 2018, so that the rate will be 0.5 percent at the end of that year.
As such, according to our assessment, the interest rate in Israel will increase
more slowly than in the US, while monetary policy in Europe is expected to
remain very accommodative for a considerable time.


As indicated in Figure 2, the expected path of the Bank of Israel interest
rate in 2017 remains unchanged compared with the previous forecast.


Table 2 indicates that the forecast compiled by the Research Department
regarding the interest rate in the coming year is similar to projections of
private forecasters and slightly higher than expectations derived from the
capital markets. However, with regard to inflation, the Research Department’s
forecast is higher than that of the professional forecasters and expectations
derived from the capital market.



Balance of risks in the

Several factors may lead to the domestic economy developing differently
than in the baseline forecast. Regarding the global environment, in the recent
period the forecasts of international institutions and those derived from the
capital market for US inflation and interest rates were revised upward. In
contrast, monetary policy in Europe is expected to remain very accommodative,
as reflected in the extension of the ECB’s asset purchase plan. This divergence
is accompanied by marked uncertainty, and in addition, there is considerable
uncertainty regarding its impact on capital markets and on the domestic
economy. In particular, there is uncertainty about the development of the
exchange rate due to the opening of yield gaps between the US, Israel and
Europe. The uncertainty regarding nominal developments is also accompanied by
uncertainty regarding the strengthening of global growth and world trade, among
other things against the background of the strengthening of the voices calling
for pulling out of trade agreements and for implementing isolationist economic
policy, which was seen in recent political developments in the UK and the US.


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 September.) 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)


Research Department Staff Forecast, December 2016




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

Research Department Staff Forecast, December 2016





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)

Research Department Staff Forecast, December 2016


The center of
the fan chart (the white line) is based on the Bank of Israel Research
Department assessment. The width of the fan is based on the Department’s
medium-scale DSGE (dynamic stochastic general equilibrium) model. The full fan
covers 66 percent of the expected distribution. The dotted line corresponds to
the previous staff forecast (published in September 2016). In terms of GDP
growth (Figure 3), until September 2016, the dotted line reflects the data and
estimates that were known at the time when the previous forecast was
formulated, while the solid line reflects the updated data and estimates (the
difference between them derives from new and data and revisions by the Central
Bureau of Statistics to the data).

of Israel Research Department.

[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]  Taxes on transportation
vehicles and domestic activity of importers contribute to GDP growth.

[4]  In January 2017, new tax
regulations are expected to come into force, regarding vehicles that pollute.
It is likely that some of the atypical consumption of vehicles derives from
purchases being brought forward against the background of these regulations. A
similar development characterized the investments item (there was a very
atypical increase in the passenger vehicle investment item) and imports.