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Expectations of increasing inflationary pressures led to the unanimous decision by the Bank of Israel to leave its April interest rate unchanged, according to minutes of the central bank's March 26 rate-setting meeting, which were released Sunday.
"Rapid economic growth in the year ahead together with the narrowing of the output gap [difference between actual and potential gross domestic product] would create inflationary pressures that would help to return inflation to within the target range," noted all departmental directors in the discussion, who recommended leaving interest rates unchanged at 4 percent for April. "The fall in the rate of unemployment to 7.7% in the last quarter of 2006, strengthens the assessment that the process of closing the output gap is proceeding faster than could have been assumed previously, and increases the probability that inflationary pressures will develop in the course of the year ahead."
The central bank's target range for inflation is 1% to 3%.
The minutes also noted that in 2007, unemployment was expected to reach 7.5%, on average, compared to an average of 8.4% in 2006. Economic theory suggests that positive output gap will lead to inflation as production and labor costs rise. Inflation generally rises when output or economic activity is above potential and falls when output is below potential. Inflation expectations in the capital market in the 12 months forward stand at 1.4%, while the average of estimates of Israeli economic forecasters is about 2.3%. At the same time, Israeli forecasters predict that the central bank's interest rate in a year's time will be at 4.2%, the minutes indicated.
The central bank said in the report that it expects the consumer price index to rise by 1% or 1.5% in the three months between March and May, following the negative indices in recent months. According to the average of local economic forecasts, the March CPI, due to be published next week, will be up by 0.2%, while the April index is expected to rise by 0.7%.
Economists at Migdal Capital Markets expect the CPI index for March to gain between 0.3% and 0.4% and the April index to grow by 0.7%.
After five consecutive months cutting interest rates, which resulted in a drop of 1.5 percentage points since November 2006, the Bank of Israel decided that given the "relatively stable inflation expectations for one year forward that more time be allowed to assess the effects of the previous interest rate reductions on inflation, and that the interest rate be left unchanged for April."
At the same time, however, the central bank pointed out that the interest rate needed to reach the inflation target was to a certain degree dependent on future exchange rate developments.
"Israel's economy is enjoying the benefits of several positive developments, the most notable of which is the current account surplus, which in 2006 reached 5% of GDP," the report stated. "The point was made that the expected surplus in the current account tends to strengthen the shekel and that over the last year, the strengthening of the shekel has been a cause of negative inflation."