Flug mulls rate hike in her final month

Karnit Flug  photo: Eyal Izhar

15 central banks raised interest rates in September but the Bank of Israel is not expected to raise the rate next week.

Next Monday, the Bank of Israel Monetary Committee will announce the interest rate in Israel for November. This will be the Committee's last meeting under the leadership of Governor of the Bank of Israel Karnit Flug, whose term ends on November 12. During her term in office, Flug led the Committee in two interest rate cuts, most recently in March 2015. The interest rate has stayed at an all-time low of 0.10% ever since.

Now, following three and a half "boring" years, the Monetary Committee's impending decision is arousing special interest. A series of signals and indications by the Bank of Israel in recent months are preparing the spadework for the start of interest rate hikes. The big question is whether this will occur already at the Committee's upcoming meeting

The most recent signal of an impending interest rate increase came the day after Rosh Hashana as part of the publication of the minutes of the Monetary Committee's last meeting. The Committee has six members, one of whom customarily supports an interest rate hike. An interest rate hike requires a majority of the Committee's members, with Flug's vote serving as a tie-breaker. At the most recent meeting, it became clear that the block opposing an interest rate hike had begun to crumble. "Another member argued that the current interest rate does not match the pace of the economy, and that the right thing to do is raise the interest rate to 0.25%," the minutes state, "but in view of the fact that the possibility of such a measure has not been understood by the financial markets, he supports leaving the interest rate unchanged at the present time."

What has changed since the previous decision? Have the financial markets already understood that an interest rate hike is a possibility in a way that can convince the Monetary Committee's wavering member, and perhaps also other members, to finally cross the Rubicon and support raising the interest rate?

"Flug will not do such a cynical thing"

The simple answer is that the markets do not expect an interest rate hike right now. For example, the prices of the Bank of Israel's short-term loan reflect expectations of an interest rate hike sometime around January-February 2019. A decision by the Monetary Committee on Monday to raise the interest rate to 0.25%, say, will come as a surprise, and if there is one thing that central banks have learned in recent years to avoid, it is surprising the markets.

There is also, however, a more complicated answer. First of all, it turns out that there is a difference between analysts in Israel and their colleagues in foreign banks, such as Citibank and Deutsche Bank. The foreigners, at least according to informal conversations, believe that there is a real possibility - "a 50% probability," according to an Israeli in regular contact with the foreign analysts - of an interest rate hike on Monday. Secondly, almost all of the analysts now agree that an increase in the interest rate will come in the coming months - if not next week - and this is something that in itself is not obvious.

"While no one took the possibility of an interest rate hike seriously a year ago, the picture today is completely different, and the credit for this belongs to the Bank of Israel, which has done good preparatory work," says Psagot Investment House chief economist Ori Greenfeld. Starting last March, the Bank of Israel began signaling to the markets that it would begin to seriously consider an interest rate hike when inflationary expectations enter the Bank of Israel's target range of 1-3%. Expectations for the increase in prices in the coming 12 months have indeed gradually increased and currently stand at around 1.3%. On the other hand, Plug restricted herself by making it clear in a July press conference that it was necessarily to inflation to be stabilized within this range in both forward expectations and the cumulative increase over the past year.

In late August, the Monetary Committee announced that inflation was beginning to stabilize in the target range. The two latest Consumer Price Indices, however, were lower than expected, and it therefore appears unlikely that the Committee will be able to find that the stabilizing process begun has been completed. The risk is that raising the interest rate in this case will damage the Bank of Israel's credibility and affect the entire forward guidance approach that it has adopted - an approach designed to coordinate expectations with the markets.

Greenfeld believes that Flug will not raise the interest rate, among other things because it is the Monetary Committee's last meeting under her leadership. "There are question marks about whether it is right for a Governor of the Bank of Israel to take such a drastic step before leaving. The message that it is important for the Bank of Israel to deliver is that the interest rate decision is not one by any particular Governor; it is a decision by the Monetary Committee," he says. Greenfeld believes that the interest rate will be raised in November, based on a prediction by the Bank of Israel Research Department of one interest rate hike in 2018. "The meeting in November will be the last one this year, and it appears likely that the Monetary Committee will prefer waiting until the end of the year."

A similar view was expressed by colleague, Harel Insurance and Finance economics and research department head Ofer Klein. "The Israeli economy is ready for an interest rate hike," he says. "The unemployment rate is the lowest that it has ever been, growth is steady, wages are rising, and inflation is at the target - the interest rate would not have been where it is today had the interest rate in Japan and Europe not been negative."

"Globes": What about the fact that 15 central banks in the world raised their interest rates in September?

Klein: "Almost all of the banks that raised their interest rate are banks of emerging economies suffering from a capital drain and double-digit inflation. This is absolutely not the case in Israel. Norway and the Czech Republic are not good examples, either. But this is still too early. The timing is determined by the indices and the exchange rate - the last two CPIs were lower than expected and the shekel exchange rate is still strong."

What about the psychological dimension? Will Flug forego her last chance to raise the interest rate as Governor of the Bank of Israel and signal that the economy is returning to normality? Will she perhaps help her replacement, who will be afraid of jumping into cold water?

"These are not Flug's guiding considerations. It is true that the Israeli economy is ready for an interest rate hike. Over the next six months, it is very likely that we will see an interest rate hike, and in the longer term, we will see more than one. The current price of 10-year bonds reflects a 2.2% interest rate, but the timing of next week is simply unsuitable. From Flug's standpoint, if it is right to raise the interest rate two months from now, she will not raise the interest rate today. Such cynicism is not like her. It is true that the probability of an interest rate hike next week is greater than zero, but it will be very difficult to find someone willing to gamble on it."

Greenfeld believes that the real question is not whether the interest rate will be raised, but whether the Bank of Israel will announce a plan for raising the interest rate over the coming year. "We are treading water about the wrong question. What is really important is what the plan is - whether there will be one interest rate hike this year and one more in 2019, or whether the Bank of Israel will feel comfortable enough, if the currency and inflation allow it, to accelerate slightly in order to store ammunition. One interest rate hike, or even two, is not real ammunition."

The concern is that the next economic crisis will find the Bank of Israel with no ammunition, i.e. without an option to lower the interest rate, which is already negative now when prices are increasing at a 1% pace. Greenfeld adds another consideration to the equation: the US Federal Reserve Board. "The Federal Reserve Board's most recent announcement, in which chairperson Jerome Powell said that he was likely to start cutting the interest rate in 2020, teaches the Bank of Israel that it is not immune forever. The US will enter a slowdown sometime, the Federal Reserve Board will stop raising the interest rate, and then the Bank of Israel will be stuck, because the last thing that it wants is to be in a situation in which it raises the interest rate and closes the interest rate gap with the US. In other words, the Bank of Israel realizes that it does not have an unlimited time in which to raise the interest rate; it has a window of opportunity that is liable to be a narrow one." In answer to a question from "Globes," Greenfeld said that he believed that the likelihood of an interest rate hike next week is around 30%. Klein is willing to settle for 20%.

"They are two to three years late in raising the interest rate"

There are also different approaches among the economists and analysts, however, and even contrary approaches, concerning the economic situation and the effect on it of an interest rate hike. In the dove camp of the analysts can be found those who believe that the Bank of Israel has no real reason to raise the interest rate, simply because it missed the boat. In the opinion of Meitav Dash Investment House chief economist Alex Zabezhinsky, the Bank of Israel should have begun raising the interest rate two or three years ago, when the economy was growing rapidly and the real estate market was red hot. "The problem is neither the exchange rate nor inflation; it is raising the exchange rate at a time when the economic is slowly cooling off. When we see the increase credit for households coming to a halt, and the last two CPIs were lower than the forecasts, the most prominent figure is the rent item, which is the core of inflation, which has gone up by only 0.4% in the past two months. This is a very surprising figures, because July-August are the two strongest months of the year. In recent years, rents went up by at least 1.5%."

So did the Bank of Israel miss the opportunity to raise the interest rate? Zabezhinsky says yes, "not by two months, but by two to three years. It should have raised the interest rate when the real estate market and growth were strong."

"Globes": Two or three years ago, inflation was negative. How could the interest rate have been raised then?

Zabezhinsky: "There was no inflation then, but the reasons why inflation was low were not related to economic activity, but to external factors, such as the drop in oil prices and the drop in the government's prices. If the Bank of Israel raises the interest rate now, when the real estate market is stagnating, it could drag the economy into a slowdown, or even a recession."

Zabezhinsky thinks that the Bank of Israel is likely to nevertheless raise the interest rate, because it does not give proper weight to the opinion and alarming developments in the real estate market and household debt. What is the likelihood of an interest rate hike? Zabezhinsky says no more than 10%.

Opinions of the question of how an interest rate hike next week is likely to affect the economy also differ. In contrast to Zabezhinsky, who believes that an interest rate hike is liable to have a substantial negative effect on economic activity, Greenfeld says that such a measure will have no real effect. "One interest rate hike should not be influential," he says. "Sentiment among investors in the market is very strong, and investors are already making their peace with an interest rate hike. Where a series of interest rate hikes is concerned, there is a question of whether the Bank of Israel will be able to calm investors. There will be an effect on the bond market and the exchange rate, but not necessarily on shares. Keep in mind that even after one or two interest rate hikes, the real interest rate in the economy will still be negative. Even at a 0.75% interest rate, the CPI will be around 1%, so it should not affect shares, assuming that the Bank of Israel is able to soothe investors, as it has done with considerable success up until now."

Published by Globes [online], Israel business news - en.globes.co.il - on October 4, 2018

© Copyright of Globes Publisher Itonut (1983) Ltd. 2018

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Karnit Flug  photo: Eyal Izhar
Karnit Flug photo: Eyal Izhar
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