(Communicated by the Bank of Israel)

Inflation: In the second half of 2011 (the period reviewed in this report) the Consumer Price Index (CPI) was unchanged, and on a seasonally adjusted basis increased at a moderate pace of 0.4 percent. The main components that contributed to the increase in the general index were housing (rents) and housing maintenance. The main factors moderating the increase were food, education and culture, and transport and communication. The inflation rate, as measured by the change in the CPI, in 2011 was 2.2 percent, near the midpoint of the price stability target range. The largest contribution, 1.2 percent, was the housing component; the CPI excluding housing increased only 1 percent.

The global economic environment: During the second half of 2011, the debt crisis in Europe deteriorated sharply, and led to a slowdown in real activity, and a sharp increase in risk in financial markets world wide. The slowdown in activity in Europe spread to other advanced economies, as well as to emerging economies, and they responded with expansionary monetary policy, primarily through interest rate reductions. In contrast US economic data surprised on the upside. With that, the US rate of growth remains low, compared with the years before the 2007-09 financial crisis.

Real economic activity: The crisis in Europe had a significant negative impact on demand for Israeli exports, and was the main factor in a slowdown in domestic real activity. Likewise, there was a slowdown in the rate of growth of private consumption, with a decline in consumer durables purchases. As a result, the rate of GDP growth slowed from about 4 percent in the first half of the year, to about 3 percent in the last six months of the year. Despite the moderation in the rate of growth, the level of activity was high, and according to most indicators, Israel's economy is near full employment.

Financial markets: Financial markets in Israel were affected by developments in the crisis in Europe, as well as by local factors, primarily the high level of political uncertainty in the Middle East. As a result, during the period reviewed, the general share index declined sharply, by 22 percent in dollar terms, and volatility increased. The decline in the stock market index in Israel was more moderate than in Europe, but sharper than in most other countries. At the same time, for the first time since the recent financial crisis, there was an increase in the yield gap between corporate bonds and government bonds - a development which indicates the market's expectation of a deterioration in the state of domestic companies.

Exchange rate: After an appreciation of about 5 percent in terms of the effective exchange rate in the first half of the year, the trend reversed in the second half, and the shekel depreciated 4.7 percent. The main factors behind the depreciation are a slide to a deficit in the current account of the balance of payments, a decline in the risk adjusted yield gap between Israel and abroad, and the continued operation of regulatory measures.

Home prices: The rate of increase of home prices over the previous 12 months moderated and reached 7 percent by the end of the year. Data for the months September-November show a slight decline in home prices, the first decline in a long time. This development indicates the possibility of a turnaround in the development of prices. Several factors were responsible for the moderation: increases in the monetary interest rate, which occurred until the second half of the year; macroprudential measures in the mortgage market; and steps by the government to increase supply, which also had an effect on prices through the public's expectations.

The macroeconomic forecast in the period reviewed: The slowdown in real activity and in inflation was expressed as well in the forecasts for 2012 which were prepared in the Bank of Israel Research Department during the period reviewed, and which serve as important inputs in interest rate decisions. In the forecast which was published on July 25, 2011, the expected rate of real economic growth in 2012 was 3.9 percent, the rate of inflation was forecast to be 2.6 percent, and these were consistent with a monetary interest rate of 4.3 percent which was forecast for the end of the year. At the end of the period reviewed, the forecast for 2012 reflected the assessments regarding the worsening of the slowdown in activity and moderation of inflation, and at the same time, the Bank of Israel interest rate reductions which had taken place. In this updated version, the Research Department forecast real activity to grow by 2.8 percent, with the inflation rate at 2.6 percent, and the Bank of Israel interest rate to be 2.2 at the end of the year, lower by about 2 percentage points than the July forecast.

Monetary policy: In the third quarter of 2011, the Bank of Israel stopped the interest rate increases it had carried out since the middle of 2009, and in the fourth quarter the Bank began a policy of interest rate reductions. The Bank of Israel interest rate was lowered by 0.25 percentage points in both October and December, and at year-end stood at 2.75 percent. The Bank continued to reduce the interest rate even after the period reviewed, and in February 2012 it was reduced by 0.25 percentage points. The switch to a policy of interest rate reductions was intended first and foremost to support real activity and reduce the cost of credit in the economy, in light of the slowdown in activity and the concern of a financial crisis in Europe. It was made possible by the moderation in the inflation environment. Concurrent with interest rate policy, the Bank of Israel continued to take regulatory steps in the foreign exchange market and the housing credit market in order to maintain financial stability and support real activity.