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Tuesday, December 25, 2012
Bank of Israel reduces the interest rate for January 2013 by 0.25%, to 1.75% 24/12/2012

Bank of Israel reduces the interest rate for January 2013 by 0.25%, to 1.75%

Background conditions

Inflation data: The Consumer Price Index (CPI) for November declined by 0.5
percent. Forecasts projected a decline of 0.1 percent, on average. This is
the third consecutive month in which the CPI has surprised to the downside.
The development of actual prices indicates continued moderation of the
inflation environment. The rate of inflation over the previous twelve months
was 1.4 percent, compared with a figure of 1.8 percent last month.

Inflation and interest rate forecasts: Forecasts of the inflation rate over
the next twelve months based on the average of forecasters' inflation
predictions, and on inflation expectations based on over-the-counter CPI
futures contracts offered by banks, declined slightly during the month, and
are currently about 1.8 percent. Expectations calculated from the capital
markets (break-even inflation) declined as well this month, to a seasonally
adjusted rate of 1.7 percent, or 2.2 percent without seasonal adjustment.
Inflation expectations for two years and longer were stable and remained at
around 2.3–2.6 percent. Expectations for the Bank of Israel interest rate
one year from now derived from the Telbor (Tel Aviv Inter-Bank Offered Rate)
market as well as expectations based on the average projection of
forecasters are for an interest rate of 1.8 percent. The forecasters who
provide projections to the Bank of Israel predict that the Bank will reduce
the interest rate by 0.25 percentage points during the first quarter.

Real economic activity: Indicators of real economic activity that became
available this month point to a continuation of the slowdown in activity,
and the GDP growth rate in the fourth quarter is expected to be lower than
the previous quarter. The slowdown can be seen in the Composite
State-of-the-Economy Index. The index increased by 0.1 percent in November,
and its low rate of growth in recent months reflects a decline in
manufacturing production and a slowdown in goods exports. The results of
various surveys of activity also indicate continued slowdown. The source of
the weakness in activity is apparently related to a slowdown in exports due
to weakness in global markets, a slowdown in world trade, and the effects of
Operation "Pillar of Defense". Some of the indicators pointing to a
moderation in activity (primarily foreign trade data) were negatively
impacted in November by Operation "Pillar of Defense", which is mostly a
temporary effect. During the fighting, about 5 percent of the workforce was
absent. During the operation there was a sharp decline in tourist entries
into Israel, and past experience has shown that this effect will likely
continue several months after the operation ended, as well. As a result of
the operation, the economy lost about 0.3 percent of GDP during the fourth
quarter (in quarterly terms).

The labor market: Labor force survey data which became available this month
indicate that the unemployment rate in the economy increased slightly in
October, to 7 percent, with a decline of 0.3 percentage points in the
participation rate, to 63.8 percent. With that, if the figures for ages
25–64 are examined (that is, the age range affected less by changes in the
survey's methodology earlier this year), it can be seen that there was a
slight decline in the unemployment rate in October, with a decline in the
rates of participation and employment. In September, the number of employee
posts continued to decline in the business sector, and continued to increase
in the public sector. The Business Tendency Survey indicates an expected
slowdown in the increase of the number of employees in the coming 3 months.
Nominal wages increased by 0.5 percent in the third quarter, compared with
the previous quarter, and real wages increased by 0.4 percent, based on
seasonally adjusted figures. Health tax receipts, which provide an
indication of nominal wage payments, were 4.8 percent higher in
October–November than in the corresponding period of the previous year,
compared with a year over year increase of 5.8 percent in September–October.

The Bank of Israel Research Department staff forecast: This month, the Bank
of Israel Research Department updated its macroeconomic forecast. In the
Research Department's assessment, the inflation rate is expected to be 1.8
percent in 2013. The Bank of Israel interest rate, which was 2 percent when
the forecast was being compiled, was expected to decline in the near term to
1.75 percent, and to then remain unchanged until at least the end of 2013.
The GDP growth rate in 2012 is estimated to be 3.3 percent. The growth rate
for 2013 is projected to be 3.8 percent, assuming that production of natural
gas from the Tamar field begins during the second quarter of 2013, as
planned, and reflects the methodology used by the Central Bureau of
Statistics regarding the recording of the gas output (and replacement of
fuel imports) in the National Accounts. Excluding the production of natural
gas from the Tamar field, GDP is expected to increase in 2013 by 2.8
percent, compared with a projection of 3.0 percent in the previous quarter's
forecast. It should be noted that gas production requires only very small
inputs of labor, and that accordingly the expected development of employment
and unemployment is determined largely by the growth rate of GDP excluding
(rather than including) gas production.

Budget data: The deficit in domestic government activity totaled about NIS
21.2 billion in January–November, some NIS 8.7 billion greater than the
seasonal path consistent with the Ministry of Finance's deficit forecast at
the beginning of 2012 (3.4 percent of GDP). Based on developments to date,
the deficit for the full year is projected to reach about 4–4.2 percent of
GDP, assuming that government expenditure does not surpass the original
amount in the budget. The accumulated deviation from the seasonal path
consistent with the Ministry of Finance's original projection results from
revenues some NIS 7.2 billion below the path, and expenditure which is about
NIS 1.5 billion above the path.

The foreign exchange market: From the previous monetary policy discussion
held on November 25, 2012, through December 21, 2012, the shekel
strengthened against the dollar by about 3 percent, an appreciation which
was especially notable compared with that of most major currencies against
the dollar. The shekel's strength occurred primarily against the background
of a renewed trend of shekel purchases by nonresidents since the end of
Operation "Pillar of Defense". The shekel appreciated by 1.5 percent against
the euro, while most major currencies weakened against the euro. In terms of
the nominal effective exchange rate the shekel appreciated by about 2
percent during the period since November 25.

The capital and money markets: From the previous monetary policy discussion
held on November 25, 2012, through December 21, 2012, the Tel Aviv 25 Index
increased by about 0.8 percent. Yields declined by about 10 basis points on
unindexed government bonds, on average, and declined by about 15 basis
points on CPI-indexed government bonds. This trend of declining yields on
government bonds was in contrast to the global trend, and occurred, among
other things, against the background of the Ministry of Finance's notice of
reduced issuance volume in the coming quarter. The yield differential
between 10-year Israeli government bonds and equivalent 10-year US Treasury
securities declined by 25 basis points, to 220 basis points. Makam yields
also declined along most of the curve, with one-year yields declining to 1.8
percent during the period. Israel's sovereign risk premium as measured by
the five-year CDS spread declined slightly during the intermeeting period to
135 basis points. The Tel-Bond 60 Index remained unchanged, but spreads in
the corporate bond market declined further, encompassing all ratings and

The money supply: In the twelve months ending in November, the M1 monetary
aggregate (cash held by the public and demand deposits) increased by 7.1
percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year)
increased by 7.6 percent.

Developments in the credit markets: The outstanding debt of the business
sector increased by 0.7 percent in October, from NIS 783 billion to NIS 788
billion; in the past 12 months the debt has increased by 3.5 percent. Total
outstanding credit to households increased in October by 0.6 percent, to NIS
386 billion. The total volume of new mortgages granted in November was NIS
4.1 billion, compared with NIS 3.4 billion in October. The balance of
housing debt was NIS 275 billion at the end of October, an increase of 7.5
percent since October 2011. Interest rates on new CPI-indexed mortgages
granted in November remained essentially unchanged, and declined in the
unindexed, floating-rate track following the reduction of the Bank of Israel
interest rate in November. About two months ago, directives from the
Supervisor of Banks went into effect, limiting the loan-to-value ratio in
new housing loans, but it is still too early to estimate their effect on the
housing market, as these directives exclude, until the end of the year,
loans which were approved in principle before the directives came into

The housing market: The housing component of the CPI (representing rents)
declined by 0.2 percent in November. In the twelve months ending in
November, it increased by 2.8 percent, compared with an increase of 2.2
percent in the twelve months to October. Home prices, which are published in
the Central Bureau of Statistics survey of home prices but are not included
in the CPI, increased in September–October by 0.5 percent, after increasing
by 0.6 percent in August–September. In the twelve months ending in October,
home prices increased by 3.7 percent, compared with an increase of 2.3
percent in the twelve months to September.

The number of building starts over the previous 12 months remains high
(38,650 in the 12 months ending in September, compared with 40,097 in the 12
months which ended in August), and it is expected to continue to be
reflected in an increased stock of homes. With that, in the third quarter
there was a sharp decline in the level of building starts, and the rate of
properties marketed by the Israel Land Administration has decreased

The global economy: This month, the OECD updated the 2013 growth forecast
for its member nations, reducing it from 2.2 percent to 1.4 percent, and
also cut its US growth forecast, from 2.6 percent to 2 percent. According to
the OECD, if the US does not resolve its budget problems (the "fiscal
cliff"), and Europe does not progress toward solving its debt crisis, the
world economy may enter another recession. Central banks in major economies
revised their growth forecasts downward. Recently, many macro data in the US
and China have surprised to the upside, while data in Europe and Japan
indicate that they are headed into recession. There was some relief in the
European debt crisis as the transfer of aid to Greece was approved. In
addition, agreement was reached on ECB supervision of major eurozone banks,
allowing those banks to receive direct aid from the euro area's permanent
crisis resolution fund, the European Stability Mechanism. The US Federal
Reserve announced the expansion of its quantitative easing program by $45
billion per month; these funds will be used to acquire Treasury securities,
and they are in addition to funds—around $40 billion per month—which the
Federal Reserve allocated in September to acquire mortgage-backed
securities. The Fed also announced that the asset purchase program and the
near-zero federal funds rate are expected to continue as long as the
unemployment rate is above 6.5 percent, and provided that the inflation
forecasts for 1–2 years ahead are not above 2.5 percent. Commodity prices in
general, and oil prices in particular, declined slightly this month.

The main considerations behind the decision

The decision to reduce the interest rate for January 2013 by 0.25 percentage
points, to 1.75 percent, is consistent with the Bank of Israel's interest
rate policy which is intended to entrench the inflation rate within the
price stability target of 1–3 percent a year over the next twelve months,
and to support growth while maintaining financial stability. The path of the
interest rate in the future depends on developments in the inflation
environment, growth in Israel, the global economy, monetary policies of
major central banks, and developments in the exchange rate of the shekel.

The following are the main considerations underlying the decision:

The development of actual prices, inflation expectations for the year
ahead, and recent months' surprises to the downside in the CPI indicate a
continued decline in the inflation environment, and apparently weakness in
domestic demand as well. Inflation over the previous 12 months was below the
midpoint of the target range, and inflation expectations for the year ahead
are near the midpoint of the target range. Commodity prices in general, and
oil prices in particular, declined slightly this month; these are expected
to have an impact on domestic prices in the future.

Indicators of real economic activity continue to point to weakness, and
further moderation in the rate of growth is likely. In addition, the
shekel's recent strength may make it more difficult for the economy to deal
with the challenges it faces. This month, the Research Department updated
its growth forecast for the coming year. Excluding the impact of the start
of natural gas production from the new field, Tamar, growth in 2013 was
revised downward to 2.8 percent, compared with 3 percent in the previous
forecast. The forecast including natural gas production is for 3.8 percent
growth. It should be noted that gas production requires only very small
inputs of labor, and that accordingly, the expected development of
employment and unemployment is determined largely by the growth rate of GDP
excluding (rather than including) gas production.

The level of economic risk from around the world remains high, and with it
the concerns over negative effects on the local economy. Growth forecasts of
major economies around the world were reduced by the central banks of those
countries and by the OECD. There is still uncertainty regarding the "fiscal
cliff" problem in the US and the debt crisis in Europe. Macro data in
Europe, including the core countries there, indicate entry into a recession;
in contrast, US and Chinese macro data surprised to the upside.

The US Federal Reserve bank announced an additional quantitative easing
program, and said that the asset purchase plan and the near-zero federal
funds rates will continue as long as the unemployment rate is above 6.5
percent and inflation 1–2 years ahead is projected to be below 2.5 percent.
Several central banks reduced interest rates this month. In addition,
markets are not pricing in an interest rate increase this year by any of the
central banks of the large advanced economies.

Home prices continued to increase in September–October. However, it is
too early to assess the impact on home prices of the LTV ratio limitations
which were imposed by the Supervisor of Banks and went into effect at the
beginning of November.

Against the background of the need to provide additional support for
economic activity and the absence of inflationary pressures at this time,
the Monetary Committee decided to reduce the interest rate by 0.25
percentage points.

The Bank of Israel will continue to monitor developments in the Israeli and
global economies and in financial markets, particularly in light of the
continuing high level of uncertainty in the global economy. The Bank will
use the tools available to it to achieve its objectives of price stability,
the encouragement of employment and growth, and support for the stability of
the financial system, and in this regard will keep a close watch on
developments in the asset markets, including the housing market.

The minutes of the discussions prior to the above interest rate decision
will be published on January 7, 2013.

The decision regarding the interest rate for February 2013 will be published
at 17:30 on Monday, January 28, 2013.

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