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Bank of Israel Governor Stanley Fischer decided to keep the shekel interest rate at 5.25 percent for July, as expected, citing forecasts that inflation over the next 12 months would be back within the target range.
"We had foreseen that the interest rate would remain unchanged, so this did not surprise us," said IBI Chief Economist Ayelet Nir.
"Inflationary pressures are on the rise, but there are two factors holding them back: the stable exchange rate and the [government decision to] reduce the VAT," Nir said, adding that, in the long term, reducing the value-added tax (VAT) could also increase inflationary pressures.
Fischer mentioned the VAT reduction's expected 0.3% short-term cut to prices among considerations leading to the decision, and estimated that increased demands and inflationary pressures resulting from the VAT reduction could be felt within a year or more.
Over the past 12 months, prices have risen 3.5%, bringing inflation beyond the government's price stability target range of 1%-3% annually. Fast economic growth, the narrowing output gap and closing the gap between the US and Israeli interest rates are factors that could push prices further up, the Bank of Israel said, adding that a "strong rise" in worker productivity was keeping prices in check.
Additional factors allowing Fischer to keep the interest rate at its current level for now are Israel's "stunning" fiscal condition - including high levels of tax revenue - and optimistic fiscal goals unveiled by Finance Minister Avraham Hirchson last week, Nir said.
In his decision, Fischer proved that he was not making interest rate decisions purely in order to maintain a 0.25 percentage-point cushion above the US interest rate, which is expected to be raised 0.25% on Thursday, closing the gap, Nir commented.
Fischer also mentioned the government's desire to pursue fiscal restraint and cut the debt, bringing the budget deficit down to 2% by 2007 and balancing the budget by 2009, improving expectations of Israel's economic performance in the eyes of both foreign and domestic investors.
Markets and analysts are anticipating a 0.5 percentage point rise in the interest rate by the end of the year, the Bank of Israel noted.
"They will have to raise [the interest rate] in the future, not today," Nir said.
The Manufacturers Association of Israel praised the Bank of Israel's decision as "justified and correct," warning against "entering an automatic track of interest rate hikes."
Separately on Monday, the Finance Ministry predicted that the GDP would grow 4.1% in 2007, slowing down from an expected 5.3% rate of growth by the end of 2006, due primarily to changes in the world economy, such as slower growth in developed countries.
Factors expected to contribute to the Israeli economy's growth nonetheless include increased investment and consumer spending, the Treasury said, adding that despite the slowdown, economic growth next year would surpass the past decade's average.
The Bank of Israel has forecast that the economy will grow 4% in 2007 and 5% by the end of 2006.