Despite heavy pressure to cut rates more, on Monday the Bank
of Israel announced that its key interest rate for July would
be 7.5 percent, only a 0.5 percent drop from the current rate
of 8 percent. The rate reduction was widely expected in the
market in view of the low inflation in Israel and the high
interest rates. Ministry of Finance officials and businessmen
had been pressing for a larger interest rate cut -- as much
as 1 percent -- arguing that the strong shekel is harming the
economic recovery.
The Bank of Israel has now lowered interest rates by a total
of 1.4 percent over the last four months. The Bank of Israel
said that inflationary expectations for the coming 12 months
were only 1.3 percent in May, at the low end of the
government's target range of 1-3 percent.
At 7.5 percent, Israeli interest rates are 6.75 percent above
the rate in the US. Also the domestic CPI has risen just 0.1
percent in the first five months of 2003. This combination
has drawn international funds in search of easy, high returns
from the high interest, which has resulted in a fall in the
shekel against the dollar of 9 percent so far this year.
The low shekel makes Israeli goods more costly in foreign
markets reducing exports, but conversely it makes foreign
goods cheaper in Israel reducing local inflation.
Some outside observers who supported the smaller reduction
said that a larger cut might send a negative signal to the
markets.
Excerpts from the Bank of Israel's announcement:
"The Bank of Israel today announced its monetary program for
July 2003, according to which the interest rate will be
reduced by 0.5 percentage points to 7.5 percent.
"This reduction in the interest rate was made possible by the
reduction in one-year inflation expectations, the continued
calm in the foreign-currency market and in the money and
capital markets, and the drop in the rate of actual price
rises. In the last two months, one-year inflation
expectations derived from the capital market stabilized, and
they are below the middle of the government's price-stability
target of 1-3 percent. Inflation expectations for the second
year ahead and beyond continued to decline, and are now in
the upper part of the target range. Private forecasters'
predictions of 12-month inflation are within the range of 1-2
percent, and 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 continuing
to reduce the interest rate. It is important to bear in mind
that the interest policy is directed towards the achievement
of price stability for the coming year and for the years
thereafter, and not necessarily within a particular calendar
year.
"The reduction in risk was reflected in the strengthening of
the NIS in the last few months and in the continued reduction
of the interest rates on unindexed long-term government bonds
to about 8.0 percent, down from about 11.7 percent in
February 2003, and in the reduction of more than one
percentage point in the yield on 10-year indexed government
bonds in that same period, to 4.7 percent. These developments
may be explained mainly by the reduced regional political
uncertainty following the conclusion of the war in Iraq, the
confirmation of the loan guarantees by the US government and
as part of the worldwide trend of improved demand for bonds
in emerging markets.
"Nevertheless, there is still a feeling of uncertainty, and
it seems that despite the budget cuts that accompanied the
approval of the economic package, the deficit this year and
in the next few years will be significantly higher than the
path set by the government. If this does occur, long-term
interest will be unable to achieve its full potential
reduction, which is necessary to encourage investment and
growth in the economy, and under certain circumstances this
could constitute a source of instability.
" . . . Further cuts in the short-term interest rate while
maintaining price stability depend to a great extent on the
government's ability to ensure fiscal discipline and to
return to a downward-sloping deficit and debt path which are
also required to strengthen the financial system.
" . . . The Bank of Israel will continue to monitor
developments in the markets, in order to ensure that the
inflation rate defined as price stability is maintained while
bolstering financial stability. Subject to these conditions,
the Bank will act to support the government's policy to
foster employment and shorten the recession."
