Communicated by Bank of Israel and Government Press Office

Jerusalem-----August 27.....The Bank of Israel today announced its monetary program for September 2001, according to which its interest rate will remain at its present level of 6.3 percent.
The Bank of Israel explains that estimates of inflation for the next few years obtained from inflation expectations in the capital market, private forecasters' assessments, and inflation estimates based on macroeconomic models developed in the Bank of Israel are currently within the target range for 2001, at the upper limit of the target range for 2002, and at the upper limit of the long-term target range. Thus, the absence of change is consistent with the achievement of the target for 2001 and the next few years. As is known, the Bank of Israel's monetary policy strives to attain the inflation targets set by the government, as the essential basis of sustainable growth and in order to continue strengthening the financial stability which the economy has demonstrated in the money, capital and foreign currency markets. This stability has been achieved as a result of monetary policy and fiscal restraint, among other things. Maintaining and cultivating stability is of special importance in the conditions of uncertainty caused by the domestic and external forces to which Israel's economy has been exposed in the last year.

The Bank of Israel notes that there is no direct connection between the decision regarding the interest rate for September 2001 and the proposal to increase the budget deficit in 2002. As is known, the decisions regarding the interest rate are intended to preserve price stability, and it is too early to tell to what extent, and when, next year's budget deficit will affect inflation. However, the proposal should be viewed in the light of the marked and rapid real growth-double than that originally planned-in government expenditure, and the significant departure from the deficit target in 2001. This has two consequences which could have a weakening effect on the economy:
First, the increase in the government's interest expenses, not only because of the more rapid rise in the government's debt but also because the long-term interest-rate trend-which tended downwards in the first half of the year but has stopped in the last two months-has been checked and there are apprehensions that it will rise once again because of the need to borrow caused by the growing deficit. A rise in the price of capital, if this occurs, will not stop at the government's doorstep. The interest rate on government bonds is the benchmark for all long-term interest rates in Israel, including that on mortgages.
Second, in the context of the budget proposal for 2002, the implementation of the budget in 2001, which has departed from its planned level, does not appear to be a one-off event, and could create the impression that fiscal discipline is relaxing. If this impression becomes entrenched this will affect the cost of the capital which the government and the private sector borrow abroad, as well as the foreign-exchange market in Israel, financial stability, and inflation expectations. Thus, additional measures are required that will afford credibility to the government's decision regarding a return to the downward path of the deficit and the government debt in 2003 and the following years.

The Bank of Israel adds that since the beginning of 2000 the rate of interest has been reduced by 4.4 percentage points (from 10.7 percent to 6.3 percent), and real short-term interest, i.e. the Bank of Israel's interest rate minus inflation expectations derived from the capital market, has come down even more rapidly, by more than 5.1 percentage points, and is currently 3.5 percent, its lowest level for three years. On the other hand, the decline in long-term interest, as measured by the yield on government bonds, has been checked, and has even risen slightly, to 4.5 percent. This was in part the result of the increase in capital raised by the government in the last few months due to the need to finance this year's expansion in the budget deficit.
The Bank of Israel points out that the decline in interest rates since January 2000 could contribute to moderating the economic slowdown that has characterized Israel in the last year. However, it should be stressed that interest-rate changes cannot offset the main causes of the economic slowdown, chief among them the cumulative influence of security incidents and the global slump, especially in the US, and particularly in the high-tech industry.

The Bank adds that the risk premium which international capital markets ascribe to Israel's economy is currently estimated at 0.7 of a percentage point (for half a year) and 1.6 percentage points (for 10 years), similar to last month's level. The interest-rate differential against the dollar is currently about 2.8 percentage points, compared with 5.2 percent in January 2000 and 2.0 percent in January 2001.