After ten successive rate hikes, the Bank of Israel Monetary Committee once again convenes next Monday for one of the most intriguing decisions of the past year. It is extremely unclear if there will be another hike, lifting the interest rate above its current 4.75%. Economists' have been chopping and changing their forecasts for this interest rate decision. A few weeks ago, the market reckoned another interest rate hike in July had a 60% probability. Immediately after the publication of the (CPI) consumer price index in mid-June, which surprised to the good and showed the annual inflation rate in Israel falling to 4.6%, the probability dropped to almost zero. In recent days the wind has again changed direction, and quite a few economists again expect another interest rate hike.
The vicious circle of the shekel and inflation
What has caused the predictions to change over the past few weeks? One of the major factors determining whether there will be an interest rate hike is the shekel exchange rate. Bank of Israel Governor Prof. Amir Yaron, said a few weeks ago that, "The exchange rate is perhaps the most important variable these days regarding inflation." According to Yaron, "For every percentage depreciation (in the shekel-dollar exchange rate), prices increase by 0.2%. We have excess inflation of at least about 1%." The central bank explicitly says that the changes in the exchange rate are mainly due to domestic factors and, "are affected by events surrounding legislative changes."
Morgan Stanley issued a report last week on the state of Israel's economy that attempted to analyze the impact of the crisis and political uncertainty in Israel on the domestic economy. According to its analysis, "In the adverse scenario, with the tensions over judicial reform persisting for longer or even escalating, a higher risk premium and shekel depreciation would translate into higher inflation, averaging 5.1% in 2023, and forcing further tightening by the Bank of Israel to 6.25%." In other the interest rate would rise by another 1.5% from its current level of 4.75%. Morgan Stanley believes that the Bank of Israel will raise the interest rate next week by 0.25% to 5% - a level not seen since 2006.
But that may be an over-simplified estimate. Morgan Stanley's forecast was issued following a degree of recovery by the shekel against the dollar. The US investment bank explained that due to lower inflation in May and a certain recovery of the shekel, it expects a 0.25% hike in July, after which the Bank of Israel will be able to gauge the effect of interest rates and the tightening of the economy so far. But since then the picture in the foreign exchange market has changed substantially with the shekel losing ground.
On June 16, the shekel-dollar exchange rate was NIS 3.56/$. Since then, the US currency has appreciated by over 4% against the shekel, crossing the NIS 3.70/$ threshold. The weakening of the shekel over the past few weeks has been mainly attributed to the judicial reform, which the coalition plans to promote unilaterally in the Knesset, starting with legislation to curtail judicial review by limiting the ability of the courts to set aside decisions by central and local government and public officials on the grounds of extreme unreasonableness.
The operation in Jenin increases uncertainty in the market
But this week an additional factor working against the shekel has been introduced - the security tensions in Judea and Samaria. Following the launching of the IDF's military operation in Jenin, the shekel depreciated by 0.5% on Monday, amid stormy trading on the local foreign, although the depreciation moderated by the afternoon. If the military operation continues, it could fuel uncertainty on the local market and push the shekel-dollar exchange rate higher.
Mizrahi Tefahot Bank chief economist Ronen Menachem said, "Past experience has shown that as long as we are talking about targeted actions, then the impact on economic activity is extremely limited." However, Menachem emphasizes that the effect on the foreign exchange market depends on the duration of the operation in Jenin. A variety of scenarios must be taken into account and it is the dynamics of the action that will affect the direction and level of trading volatility, as long as it lasts."
IBI chief economist Rafi Gozlan said that the Jenin operation is a secondary factor in weakening the shekel. "The market has learned from military operations and does not attach much weight to it," he explains. "The judicial issue is the dominant one that causes the weakening of the shekel and increases the probability of an interest rate increase next week, as the depreciation continues."
Gozlan estimates that only if the shekel-dollar exchange rate remains above NIS 3.7/$, the Bank of Israel may raise the interest rate. "When you look at the development of inflation, you see that the component that moderates the increase is the tradable products, which are affected by the exchange rate. Thus, as the depreciation increases, general inflation will be higher, and will lead to continued interest rate hikes."
Bank Leumi believes that the central bank "will take a timeout and leave the interest rate unchanged in the upcoming decision", and even predicts that "the Bank of Israel may be able to leave the interest rate unchanged until the end of the year". But they also believe that the exchange rate will also have an impact on the continuation of interest rate hikes.
Published by Globes, Israel business news - en.globes.co.il - on July 3, 2023.
© Copyright of Globes Publisher Itonut (1983) Ltd., 2023. .