Tomorrow (Monday), the Bank of Israel is expected to raise its interest rate as part of the battle against inflation. An interest rate rise was inevitable even before the release of two important macro figures last week that radically affected the picture: the Consumer Price Index reading for July, which indicated a twelve-month inflation rate of 5.2%, and the strong economic growth figures showing GDP rising at an annual rate of 6.8% in the second quarter, contrary to expectations of a slowdown. These data will make it hard for Governor of the Bank of Israel Amir Yaron to suffice with a moderate rise of 0.5% - a number that until not long ago was considered aggressive.
A steep interest rate rise now and an easing afterwards, or front loading, is what lies behind the Bank of Israel’s moves on interest rates as it battles above-target inflation. The July CPI reading, which was way above market estimates, together with the strong growth numbers, point to a sharp interest rate hike by the Bank of Israel, but beyond that the question should be asked, what has changed since the last interest rate decision in July?
If up to a week ago, the expectation on the capital market was that the interest rate would rise by 0.5% in the forthcoming decision, the July CPI reading was 0.6% above estimates and represented a 14-year peak in inflation, and a 1.1% rise in consumer prices in one month cannot be ignored. Although the price rises in July were partly seasonal, such as air fares, inflation is broadening its hold, and the market is now pricing in an interest rate rise of 0.75%.
It’s not for nothing that inflation is called "the silent killer". The public is gradually starting to feel the rise in prices at the supermarket, in rents, in entertainment, and so on, and the Bank of Israel has to rein it in, the sooner the better. But perhaps the hour has already passed? At the end of last year, there was only one vote on the Bank of Israel Monetary Committee in favor of raising the interest rate. Since that member left the committee, the votes have been unanimous. There are those who will say that the central bank should have acted then and not waited. It has raised its rate three times this year, and the moderating effect on the economy has yet to arrive.
If it wishes, the Bank of Israel can continue to claim that inflation in Israel remains low by international comparison: with the UK, for example, where the rate of inflation reached 10% last week, or with the US, where annual inflation has moderated to 8.5%. Still, Israel’s inflation rate is 2% above the target range, and it’s hard to see how measured interest rate hikes can be justified, other than by expectations of falling inflation next year, as in the Bank of Israel’s forecasts. The Ministry of Finance, by contrast, sees inflation starting to moderate only in 2024.
While other countries are recording economic slowdowns and facing gloomy forecasts about future growth. Israel stood out positively in the second quarter of 2022 with surprisingly strong growth.
The market expected weaker figures, among other things because of a decline in credit card purchases, which accelerated at the end of the first half of the year, and the slowdown in the high-tech industry because of global conditions. The annualized 6.4% rise in GDP was the steepest in the West on a comparison of the second quarter of 2022 with the corresponding quarter of 2021. So where is the slowdown in high-tech that everyone is talking about? The number of job vacancies in the industry has been steadily declining since February, in parallel with the sharp falls on the stock markets in the first half year.
In its forecasts for 2024-2025, the Ministry of Finance does not assume surpluses in tax collection from the industry, but the Bank of Israel is not concerned at the slowdown, as it sees the industry as more diversified than it was in the dot.com collapse of 2020.
What will it take to restrain the housing market?
Those for whom a home purchase is looking ever more distant will say that a minimum interest rate rise of 1% is needed now to curb prices. But such as sharp rise would hit those repaying mortgages very hard. If in the wake of the July CPI figure people were wondering on social networks why their mortgages had suddenly become more expensive (inflation was affecting index-linked loans), after an interest rate rise the prime rate, which is based on the Bank of Israel’s rate, will add to the effect and raise monthly repayments further.
The housing market, although it continues to reach new peaks, is not, however, the Bank of Israel’s first concern. Its mandate is to maintain price stability, and it attributes the problems of the real estate market to a shortage of homes, and that is the responsibility of the government, which for the time being has failed to rein in prices, which have been rising at a rate not seen for a decade.
Arguments for a moderate hike
The governor of the Bank of Israel explains that at every meeting of the Monetary Committee the members look at the economic data before reaching a decision, and the question is how the central bank will justify a sharp interest rate hike when since the last meeting prices of oil and other commodities have fallen sharply from their peaks and the shekel has appreciated at an exceptionally rapid rate. Since the July interest rate announcement, the shekel has appreciated by 8% against the basket of currencies of Israel main export markets, as prices on financial markets rise. The renewed strengthening of the shekel will contribute to moderation of imported inflation, but a very large interest rate hike will, on the face of it, bring about further strengthening of the shekel, and thus hit Israel’s exporters.
According to the Bank of Israel’s model, rapid appreciation of the shekel such as we have seen recently is equivalent to an interest rate hike of 1.5%. On the other hand, the recent appreciation has only canceled out the depreciation in the first half of the year. The effect on inflation of the appreciation of the shekel will find expression only later. Meanwhile, the falling price of oil will reduce inflationary pressures.
A global view
The Bank of Israel’s Research Department sees an interest rate in a year’s time of 2.7%, and it must be remembered that the Bank of Israel does not act in isolation from the world. Worldwide, interest rates are being raised in order to curb inflation. The rise in US stock markets in recent weeks is connected to comments by the US Federal Reserve on the possibility of a halt in the rise in interest rates to test the effect on inflation, which is starting to show signs of moderating in the US. Nevertheless, the Federal Reserve is expected to continue raising rates. The protocol of the last meeting of the Federal Open Market Committee indicated determination to peg inflation back to 2%. And while the US recorded negative growth in the second quarter, in Israel, as mentioned, not only was there no slowdown, but growth remained strong, which makes a sharp interest rate hike tomorrow highly likely.
Published by Globes, Israel business news - en.globes.co.il - on August 21, 2022.
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