The rate cut by the Bank of Israel (BoI) was a surprise move and the bank's Monetary Policy Committee said the decisions were reached "outside the regularly scheduled framework." The next scheduled meeting of the committee is May 27.
The BoI said it plans to buy about $2.1 billion of foreign exchange this year to offset the impact of the improvement in Israel's current account from drilling of natural gas in the Tamar field. Production from the field, in the Mediterranean Sea off Israel's coast, started end-March.
At its last meeting in March, the BoI had said economic activity was continuing to improve but it was still too early to determine if the economy had turned the corner. In 2012 the BoI cut rates by 100 basis points but had left them unchanged so far this year.
In a statement, the BoI said the effective exchange rate of the shekel had appreciated by 5.4 percent in the past three months, noting the rise against the U.S. dollar and euro as this contrasted with the movement of other currencies.
"The appreciation trend was affected by, among other things, the beginning of natural gas production from the Tamar gas field, the interest rate reductions by central banks worldwide, notably the ECB, and the continued quantitative easing programs in several major economies around the world," BoI said.
It added that global growth forecasts, particularly of Europe and China, had been revised downward and this moderation in growth is expected to affect Israel.
It also noted that inflation was below the the midpoint of the BoI's target range and was expected to remain within the range in the coming year, while recent actions by banking supervisors were moderating the impact of the bank's policy rate on the housing market.
Israel's inflation rate eased to 1.3 percent in March from 1.5 percent, in the low end of the BoI's target of 1-3 percent.
In March the BoI's staff forecast economic growth of 2.8 percent this year and 3.3 percent next year, excluding the impact of natural gas drilling at Tamar. In 2012 Israel's Gross Domestic Product expanded by 3.1 percent.
Including the effect of gas drilling, growth is forecast at 3.8 percent this year and 4.0 percent in 2014.
Revenue from natural gas production from the Tamar field is improving Israel's current account and this is putting upward pressure on the shekel and threatening the competitiveness of Israel's economy - a phenomenon known as the "Dutch disease"
The BoI's policy committee said it had approved a plan to "offset the effect of the natural gas production on the exchange rate."
Starting this year, the BoI would purchase foreign exchange in line with its assessment of the improvement in the current account from gas production. This is estimated to be about $2.8 billion and taking into account payments by the gas companies, the BoI said it would purchase about $2.1 billion of foreign exchange by the end of this year.
The BoI said the purchase of foreign exchange to offset natural gas production is in addition to its normal operations in the foreign exchange market. The BoI sometimes intervenes in the market when the exchange rate is "not in line with fundamental economic conditions, or when conditions in the foreign exchange market are disorderly."