(Communicated by the Bank of Israel)

Background conditions

Inflation data: The Consumer Price Index (CPI) increased 0.5 percent in August, at the upper limit of forecasts and above the seasonal path consistent with achieving the inflation target. Inflation over the past 12 months, as measured by the change in the CPI, was 3.4 percent, above the upper limit of the target inflation range (of 1-3 percent a year). With that, the rate of inflation, seasonally adjusted, over the past six months has been around the lower limit of the inflation target range.

Inflation and interest rate forecasts: Inflation expectations for the next twelve months as calculated from the capital markets were steady over the past month and remain at 2 percent on average. Forecasters' inflation predictions for the next twelve months continued to fall, to 2.3 percent. The background to the convergence of inflation expectations to the midpoint of the target range, despite the depreciation of the shekel seen in the past several weeks, was continued expectations of a slowdown in growth in Israel and worldwide, and apparently also a process of lowering prices by retail chains and various service providers, as part of the impact of social protests against the high cost of living. At the same time, forecasts of the Bank of Israel interest rate continued to fall. Based on the Telbor (Tel Aviv Inter-Bank Offered Rate) market, the Bank of Israel interest rate one year from now is expected to be 3 percent, down from 3.1 percent a month ago, and the average of forecasters' predictions is that it will be 3.15 percent, down from 3.6 percent a month ago. Most forecasters expect the Bank of Israel to leave the interest rate for October unchanged. 

Real economic activity: Economic activity continued to expand, but at a slower pace than in 2010 and the first half of 2011. Economic indicators that became available this month indicate stabilization of activity in the high tech sector and in exports, because of the moderation of activity abroad. Growth of real GDP of the business sector in the second quarter, according to the second National Accounts estimate for that quarter, was at an annual rate of 2.4 percent - slightly higher than the first estimate, a result of an upward revision in exports, in private consumption, and in investment. The moderate pace of activity was seen in the composite state of the economy index, which increased 0.3 percent in August, along with a slight upward revision in the index for June and July. Tax receipts grew in real terms, but are still below the seasonal path, for the fifth consecutive month. The Central Bureau of Statistics survey of business trends for August shows declines in all industries. With that, for all industries except the hospitality industry and high tech industries, the expectations for the next three months are for improvement in volume of activity. The "Globes" and the "Bank Hapoalim" consumer confidence indices point to a decline in the public's planned consumption, although both indices show that the public remains optimistic about the economy in the future. 

The labor market and wages: Labor market data for the second quarter indicate a continued improvement in employment. In the second quarter, the unemployment rate continued to fall and reached the low level of 5.5 percent, with stability in the participation rate and an increase in the employment rate. The number of employee posts (seasonally adjusted) increased by 0.4 percent in April-June compared with the preceding three months. The ratio of number of the unemployed to the number of job vacancies shows that in the business sector, there are 2.5 unemployed persons for every job vacancy - a historically low ratio, and similar to that recorded before the crisis. The nominal wage rose in April-June by 1.1 percent, compared with the three previous months, and the real wage (seasonally adjusted) rose 0.4 percent. In August, health tax receipts, which provide an indication of wage payments in that month, were 7.5 percent higher (preliminary estimate), in nominal terms, than in August 2010 (excluding the effect of legislative changes). 

The Bank of Israel Research Department staff forecast: The Research Department staff forecast was updated this month. The current assessment is that inflation in the four quarters ending in the third quarter of 2012 will be 2.3 percent, and the average interest rate for that quarter will be 3 percent. For the full year of 2011, the Research Department forecasts that the inflation rate will be at the upper limit of the target range, and that the average interest rate in the fourth quarter will be 3.25 percent. GDP growth forecasts for 2011 and 2012 were revised lower. The current forecast is for 4.7 percent growth in 2011 (down from 4.8 percent in the previous forecast) and 3.2 percent in 2012 (down from 3.9 percent in the previous forecast). The assessment was based on, among other things, a lowered International Monetary Fund (IMF) forecast for global growth and world trade. The Research Department emphasized the primary risks faced by Israel's economy, specifically, the risk of a global slowdown and geopolitical risks that could have economic consequences.

Budget data: Government domestic revenues in August were 9 percent lower than the forecast seasonal path, due to a continued slowdown in indirect tax revenues. Tax revenues for the year to date, through August (net of legislative changes and one time revenues), were 5.3 percent higher, in real terms, than in the corresponding period of the year before, but 1.6 percent below the seasonal path of the budget forecast. The government's domestic activity in the first eight months of this year (excluding net credit) resulted in a cumulative deficit of 0.7 percent of GDP, compared with a deficit of 1.6 percent of GDP in the corresponding period of 2010.

Developments in government activity so far indicate that the budget deficit for the full year of 2011 will likely be slightly below the deficit ceiling set by law (3 percent).

The foreign exchange market: From the previous monetary policy discussion held on August 28, through September 23, the shekel depreciated by about 2.7 percent against the dollar, a significant depreciation relative to other currencies against the dollar. At the same time, the shekel appreciated 4.6 percent against the euro. The shekel strengthened by about 2.2 percent in terms of the nominal effective exchange rate. The rate of participation by nonresident investors in foreign currency trading was 31 percent in September, similar to the level in August, while the average for the year to date in 2011 is 34 percent. This month, S&P raised Israel's credit rating.

The capital and money markets: From the previous monetary policy discussion held on August 28, through September 23, the Tel Aviv 25 Index fell by 5 percent, similar to returns at most stock markets around the world. In the government bond market, the yield curve of unindexed bonds steepened, with drops of 14 basis points in maturities of up to 1 year and increases of up to 8 basis points in other maturities. Yields on CPI-indexed government bonds rose by up to 8 basis points for most maturities. The yield gap between Israeli 10-year government notes and 10-year US Treasury notes continued to widen during the period surveyed, as there was a sharper drop in yields in the US, and at the end of the period stood at 292 basis points (up from 262 basis points at the beginning of the period). Makam yields fell by up to 20 basis points across the yield curve, as the yield for one year fell during the period from 3.08 percent to 2.98 percent.

Withdrawals from mutual funds specializing in corporate bonds continued this month, although at a slower pace than that in the previous month. Since the beginning of September withdrawals totaled NIS 2.2 billion, compared with withdrawals of NIS 4.6 billion in August. In contrast, money market funds continue to attract new investment, though at a more moderate pace than in previous months, and since the beginning of September about NIS 631 million flowed into those funds, compared with NIS 4.4 billion in the month of July and NIS 3.65 billion in August. The negative sentiment in the corporate bond market, especially in holding companies, was evident in the continuing rise in yields of several companies. Over the period as a whole, Israel's sovereign risk premium as measured by the five-year CDS spread continued to rise, against the background of geopolitical events, and widened from 166 basis points to 218 basis points.

The money supply: In the twelve months ending in July the M1 monetary aggregate (cash held by the public and demand deposits) increased by 3.6 percent, and the M2 aggregate (M1 plus unindexed deposits of up to one year) increased by 12.6 percent. 

Developments in the credit markets: The balance of outstanding credit to the business sector increased in July by 0.9 percent, to NIS 757 billion. Outstanding credit to households increased by 0.3 percent in July, to NIS 357 billion. Of the credit to households, outstanding housing credit rose 11.6 percent in the twelve months ending in July, to NIS 253 billion, compared with an 11.9 percent increase in the twelve months to June. The volume of new housing credit granted in the twelve months ending in August was 1.4 percent lower than in the twelve months ending in July. The share of mortgages at floating interest rates (for all periods) in total new mortgages continued to decline in August, and reached 76 percent, compared with 79 percent in the month before. The interest rates on CPI-indexed and unindexed floating rate mortgages continued to increase in July, while the interest rates on variable rate unindexed mortgages declined.

The housing market: Activity in the construction industry continues to be strong. The number of starts in the twelve months to June reached 42,757 and the number of completions was 33,613, figures which were very similar to the levels of the previous month. The number of new homes sold fell, and in May-July was 9.6 percent lower than in February-April. The number of homes available for sale continued to increase, and in May-July was on average 6.4 percent higher than in the three preceding months. Home prices, which are published in the Central Bureau of Statistics survey of home prices but are not included in the CPI, increased at a monthly rate of 0.4 percent in June-July, after rising 0.2 percent in May-June.

The annual rate of increase in home prices continues to slow, and in the twelve months ended in June home prices increased by 12.3 percent; compared with a 12.1 percent increase in the May figure and a 14 percent increase in April. The slowdown in the rate of increase in home prices was affected by the increase in the interest rate, measures introduced by the Bank of Israel affecting mortgages, and steps taken by the Ministry of Finance in real estate taxation, together with the continued increase in the number of building starts. In contrast, the housing index, which is based mainly on renewed rental contracts and which is included in the CPI, continued to increase, rising by 1.3 percent in July, bringing the increase in the last twelve months to 5.2 percent. 

The global economy: This month, most macroecononomic figures published in the US and the eurozone were weak. The debt crisis continued to worsen this month as well: in Greece, CDS spreads indicated a growing probability of default in the near future; in the past week S&P cut its credit rating for Italy, with a negative outlook; there was growing concern of the European debt crisis spreading to the banking system, and amid that, credit ratings on large banks in the US, France, and Italy were cut.

Against the background of increasing risk and negative macroeconomic data, investment banks and the IMF lowered their growth forecasts for major economies and for the global economy. The IMF revised its 2012 forecasts of global growth from 4.5 percent to 4 percent, and of world trade figures from 6.7 percent to 5.8 percent. The IMF also cut its forecast for US economic growth in 2012 from 2.7 percent to 1.8 percent, and cut its forecast for economic growth in Europe in 2012 from 1.7 percent to 1.1 percent, and assessments are that the balance of risks is to the downside.

Within the framework of efforts to deal with the negative developments, there were several announcements this month: eurozone leaders announced unstinting support for Greece; five important central banks announced the extension of credit lines in dollars to banks in Europe; in the US, President Obama presented an incentive plan worth $447 billion to support jobs, and according to Moody's, if the jobs plan is passed, it will add another 2 percent to US economic growth next year and lower the unemployment rate, currently at 9.1 percent, by 1 percent. Inflation expectations around the world remain low, in light of the expected slowdown in economic activity and the decline in commodity prices. Inflation expectations around the world remain low, in light of the expected slowdown in economic activity and the drop in commodity prices. Currently, markets and investment banks forecast an interest rate cut by the European Central Bank (ECB) as soon as in its upcoming meeting. In the past week, the Fed announced a program to sell short-term securities and buy longer term bonds (Operation Twist), and left in place its assessment that the federal funds rate will remain at its current near-zero level through at least the middle of 2013.

The main considerations behind the decision

The decision to reduce the interest rate for October to 3 percent is based mainly on the negative turnaround in the global economy, is consistent with the return of inflation to within the target range of price stability, and is intended to support growth while preserving financial stability.

• Assessments have firmed recently that the slowdown in global growth will be steeper than previously expected. The IMF reduced its forecast of US growth in 2012 from 2.7 percent to 1.8 percent, and growth in the eurozone from 1.7 percent to 1.1 percent and it is assessed that the balance of risks is negative.
• The weakness of the US and European economies led policymakers in those countries to adopt more expansionary measures (Operation Twist in the US, and other steps in the eurozone to increase liquidity). There are now market expectations of a cut in the ECB interest rate. In addition, volatility has increased on capital markets around the world, and the downward trend in prices of financial assets continues.
• The more severe global slowdown is reflected in a slowdown in the growth of real activity in Israel, and in particular in the weakness of goods exports. The Bank of Israel has lowered its growth forecast for 2012 from 3.9 percent to 3.2 percent, and in the Israeli economy too the balance of risks is to the downside.
• Inflation expectations for the next twelve months as calculated from the capital market have remained stable this month around the midpoint of the 1-3 percent target range, and those of the forecasters continued to decline towards the midpoint of the inflation target range, and are currently 2.3 percent. The cumulative change in the last six monthly CPI readings, seasonally adjusted, is consistent with the target inflation range. Nevertheless, inflation over the previous twelve months, 3.4 percent, is still above the target range. The Bank of Israel's staff forecast and professional forecasters' expectations of the inflation rate over the previous twelve months at the end of 2011/beginning of 2012 are within the target range.
• The rate of increase in house prices in the last twelve months continues to be high, but in the last few months some moderation has been evident, and in the twelve months to July the rate was 12.3 percent (compared with 12.5 percent to June). The effects of the measures taken by the Bank of Israel with regard to mortgages, changes in real estate taxation introduced by the Ministry of Finance, and the sustained increase in building starts are expected to continue to contribute to this moderation in the coming year.

The Bank of Israel notes the strength of the Israeli economy, which is reflected in the high levels of growth and employment to date, the robust domestic banking system, the high level of foreign currency reserves, the downward trend in the government debt burden, and in Israel's raised credit rating. The cut in the interest rate for October is intended to minimize the negative effect on Israel's economy of the slowdown in activity and the increased level of uncertainty in the global economy.

The Bank of Israel will continue to monitor developments in Israel's economy and the global economy and in the financial markets. The Bank will use the instruments 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, including keeping a close watch on developments in the assets market, and especially in the housing market.