(Communicated by the Bank of Israel)

Monetary policy: For the year to date, through the end of June 2012 (the period reviewed in this report), the Monetary Committee of the Bank of Israel reduced the interest rate once, for February, by 0.25 percentage points to a level of 2.5 percent and left it at that level until the end of the period. Subsequent to the period being surveyed, the Committee decided to lower the interest rate for July by 0.25 percent, and to leave the interest rate for August unchanged at 2.25 percent. Monetary policy was formulated to strengthen the ability of the economy to deal with the deepening recession in the global economy and with its potentially adverse effects on Israel's economy. The policy decisions during the period being surveyed were subject to a high level of uncertainty regarding the trend in GDP, as the indicators of economic activity were mixed. Thus, although there were indicators of continued slowdown in the growth of GDP, there were also indicators of stable growth and even some acceleration.

Inflation: In the half year surveyed, the CPI rose by 1.0 percent since the beginning of the year. The trend of decline in the annual rate of increase in the CPI, which began in July 2011, continued in the half year reviewed. At the end of the period, the rate of increase was only 1.0 percent, at the lower bound of the inflation target range. Excluding the housing and energy components, the CPI declined by 0.6 percent during the previous 12 months. Expectations of inflation for the next 12 months rose during the first quarter to 2.5 percent and then returned to the center of the target range during the second quarter.

Real economic activity: The economy's annualized rate of growth slowed during the period being surveyed to about 3 percent. The slowdown in the growth rate of the domestic economy, which began in the second quarter of last year, continued during the six months being surveyed. Consumption, exports and fixed capital formation increased moderately while imports rose sharply. The unemployment rate increased somewhat during the period being surveyed, as did the rates of employment and participation. However the rate of unemployment was still low compared with the past.

The global economic environment: The level of economic activity in the eurozone was unchanged during the first quarter of the year and it appears to have contracted during the second quarter, simultaneous with the worsening debt crisis in a number of eurozone countries and the increasing concern that one or more countries will leave the eurozone. In the major emerging economies, the slowdown in growth intensified. In the US, moderate growth continued in the first quarter; however, during the second quarter, indicators again pointed to a weakening of activity. The central banks intensified their expansionary monetary policies through maintaining low interest rates and continuing the injection of liquidity into European markets.

The exchange rate: The shekel strengthened against the euro and weakened against the dollar; however, it remained stable in terms of its nominal-effective exchange rate, though it depreciated somewhat towards the end of the period—a depreciation which continued and strengthened afterwards as well. The relative stability in the nominal-effective exchange rate of the shekel during the six months being surveyed is a result of two offsetting forces: the deficit in the current account and the decline in the interest rate gaps relative to abroad (following the reduction in the interest rate for February), which provided support for a depreciation; and the favorable situation of the Israeli economy relative to other countries, which provided support for an appreciation.

The financial markets: In contrast to leading share indices worldwide, the share markets in Israel fell during the first half of the year, accompanied by a decline in trading volume. The yield to maturity of government bonds, both indexed and unindexed, declined during the period being surveyed, similar to the trend worldwide. In contrast, the yield gaps between corporate and government bonds widened, due to the effect of increases in the yields on bonds of a number of large business groups in the economy. The financial holdings of nonresidents, primarily in government bonds and makam, continued to shrink during the period being surveyed. Total credit to the business sector increased by 3.1 percent during the period being surveyed (until May, in annual terms), after having risen by 3.2 percent in 2011. The ratio of business credit to business sector output continued to remain stable.

Home prices: The rate of increase in home prices continued to moderate during the half year being surveyed, a trend that has continued since the beginning of 2010, and reached an annual rate of growth of 2.1 percent in April. Nevertheless, the decline in home prices during the last half of 2011 was halted during the period being surveyed. There was a minor upturn in activity in the housing market during the first half of the year, which was reflected in the increased volume of mortgages and number of transactions. Furthermore, the level of building starts is still high, though it fell last year, and this is having an effect in the direction of lower home prices.

The forecast: [1] Based on the staff forecast which was formulated at the end of June 2012, the Research Department estimates that the rate of inflation during the next four quarters will reach 2.4 percent, which is somewhat above the center of the inflation target range and somewhat lower than the previous forecast of 2.6 percent. The rate of growth in GDP is expected to total 3.1 percent in 2012, which is a continuation of the moderate growth during the second half of 2011 and is unchanged relative to the previous forecast. According to the forecast, the Bank of Israel interest rate is expected to remain unchanged at a level of 2.25 percent until the end of 2013, in view of the expected continuation of the slowdown in real economic activity and the expected inflationary environment during the coming year. The expected path of the interest rate is lower than in the previous forecast, which estimated that the interest rate would remain unchanged at 2.5 percent. The main risk to real economic activity in Israel is the possibility of a financial crisis in Europe that would lead to a worsening of the recession there. During the month of July 2012 (after the period being surveyed), there were additional indicators (and revisions) that strengthened the assessment of an actual and expected slowdown in economic activity. Should these indicators remain at such levels, it may be assumed that as part of the next forecast by the Research Department (at the end of September 2012) the forecasts of inflation and growth for 2013 will be revised downward.

[1] The last forecast during the period being reviewed was presented on June 25th, 2012, the date of the publishing of the interest rate decision for July 2012. The forecasts that were presented to the Committee during the period being surveyed will be discussed below.