In his final sentence in yesterday's press conference after announcing a rate hike of 0.5%, in answer to the final question, Bank of Israel Governor Prof. Amir Yaron gave a warning which hinted that the Bank of Israel and the new government could be on a collision course.
Prof. Yaron talked about the possibility that the budget that the incoming government will pass will increase the deficit more than forecast, fueling inflation. Such a scenario, the Governor imp0lied, could lead the Bank of Israel to a more rigid interest rate path. Or in the words of Prof. Yaron: "If there is a very, very large expansion (of the budget). It will affect inflation and this is something we will also have to take into account in our future policies."
The budget meets coalition commitments
In its decision this week, the Bank of Israel raised the interest rate by 0.5% to 3.75%, thus completing seven interest rate hikes totaling 3.65% since last April. According to the forecast of the Bank of Israel research department, the interest rate hikes will reach 4% this year, and then remain at this level for a period of time. But as Yaron stressed, and as we have already seen over the past year, everything is subject to change. If anything, it seems that the change may be upwards, to a higher interest rate.
The Bank of Israel interest rate is already "restraining" the economy, meaning that it slowing down activity. According to the Bank of Israel's research department, in 2023 GDP growth will slow to 2.8%, while unemployment will rise to 4% (in the US and Europe, the governor said growth would be zero). All this is in order to return to price stability. According to the Bank of Israel, inflation in Israel will remain high for the next two months, and then start to fall. The Bank of Israel sees 3% inflation in 2023, at the top end of its annual target range of 1% to 3%, falling to the mid-range of 2% in 2024.
This is only a forecast, and there are a range of factors that can disrupt it. "Risks to the forecast", as they are called by the Bank of Israel. Some of the risks come from abroad. For example, the war in Ukraine and a cold winter in Europe that will lead to an increase in energy prices, as well as the situation in China. But there are also "domestic risks", and they could be posed by government policy.
The incoming government clearly plans to increase expenditure, and there are a number of commitments that were included in the coalition agreements. But to both the politicians and the Bank of Israel, it is clear that not all of these commitments will be honed. This is the nature of coalition agreements. So the forecast takes into account that in practice, the budget will increase "only by a portion of the estimated cost of the coalition agreements," and in addition, that the wage agreements to be signed in the public sector will only include "moderate" wage increases.
But what if the additions to the budget are larger than expected, resulting in a larger deficit? This is the domestic risk referred to in the Bank of Israel's forecast, and Yaron referred to it. He said, "The greater the fiscal expansion, then inflation, the debt-to-GDP ratio and the returns on the capital market will be higher than those shown in the forecast."
What is implied by this sentence, but not explicitly stated, is that all of these will lead the Bank of Israel to hike the interest rate even higher. This is the only way that the sentence with which the Governor chose to end the press conference can be understood: "It will affect inflation and this is something we will also have to take into account in our future policies."
So far Minister of Finance Bezalel Smotrich has expressed himself in a similar spirit to the Bank of Israel Governor. At his inauguration ceremony earlier this week, he spoke about budgetary responsibility, restraint, and maintaining frameworks. It is yet to be seen how these emphases will be reflected in the actual budget.
In addition to questions concerning the budget as a whole, such as how much the budget is, and how big the deficit is, there is also a separate question, which is what the budget contains, and where the money goes. Will it be dedicated to programs that "encourage growth and those that benefit the entire population," as Amir emphasized? Upon taking office, Smotrich spoke of a budget "biased towards growth and infrastructure development." But investment in human capital and the population as a whole are not exactly the emphases at the heart of the coalition agreements. Here too, it is as yet unclear what the actual budget will look like.
Published by Globes, Israel business news - en.globes.co.il - on January 3, 2023.
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