In a new report on Israel, Morgan Stanley says, “Inflation pressures are no longer hidden behind the exchange rate effect. The consumer price index (CPI) recorded a shocking 1.1% increase in July, exceeding our own forecast of 0.8%, but still in line with our overall reading of inflation dynamics. As a result, the year-on-year inflation rate moved from minus 0.7% in June to 0.3% last month. Although the latest figure is below the lower limit of the central bank’s target range, it nevertheless represents a turning point. The cumulative increase in the CPI since March reached 2.3%, and the seasonally adjusted annualized inflation rate over three months surged from minus 1.5% in April (and an average of 0.1% in the first five months of the year) to 1.4% in June and then 5.5% last month. That means inflation may even exceed the upper limit of the target range by the end of the year.”
The investment banks believes, “The shekel’s behavior is the dominant factor in the short term. For example, the appreciation of the exchange rate lowered currency-linked prices and consequently the headline inflation rate from 3.8% in April 2006 to -1.3% this year. However, this was just a temporary phenomenon, not real deflation. Indeed, a closer examination of the data reveals that inflation excluding the currency pass-through effect has already been above the central bank’s target. This is why the shekel’s recent depreciation will now unveil “hidden” inflation pressures in the Israeli economy. Consumer price inflation will keep increasing in the coming months. According to our projections, consumer price inflation will spike from 0.3% in July towards 3% in the next three months and may even exceed the upper bound of the target range by the end of the year. Inflation pressures come through two separate channels. First, the swing from currency appreciation to depreciation has already turned into a major source of inflation... Thanks to a favorable global backdrop and the lagged effects of monetary easing, the strengthening of domestic demand has pushed real GDP growth to 6.5% this year - well above the potential growth rate of 4.5%, according to our estimates. As a result, there is no longer a dis-inflationary slack in the Israeli economy and the risk of exceeding the inflation target is now significantly higher.
“The Bank of Israel is likely to raise short-term interest rates to 5% by the end of this year. We have long been arguing that short-term interest rates are below the neutral level when in fact the aggregate demand-supply balance in the economy requires restrictive monetary policy. This is why the prolonged period of policy misalignment ended up creating a burst of currency and inflation volatility, consequently forcing the Bank of Israel to tighten its policy stance by 25 basis points to 3.75% last month. In our opinion, this is just the beginning of a monetary normalization process that is likely to bring short-term interest rates to 5% by the end of this year. But is this just going to be a gradual tightening cycle with 25 basis points rate hikes each month? That could well be the case as long as the shekel makes no wild moves on the downside. Unfortunately, even though it is holding up so far in the intensifying global financial turmoil, the negative interest rate differential still keeps the shekel vulnerable to sudden changes in global (and domestic) risk appetite. Therefore, the Bank of Israel may opt for fast-track normalization and raise interest rates by 50 basis points to 4.25% at the end of this month. A more cautious approach would indeed be better for economic and financial stability, since growth remains robust and inflation is already on the rise. In either case, we expect monetary tightening to support the undervalued shekel and help normalize the yield curve, assuming of course the liquidity squeeze does not turn into a full-blown global crisis.
Published by Globes [online], Israel business news - www.globes.co.il - on August 19, 2007
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