30 months have passed since the Bank of Israel last changed its interest rate. In March 2015, the Bank of Israel's Monetary Committee lowered the rate to an all-time low of 0.1%. There have been many interest rate decisions since then, but the most interesting of them, and possibly the most surprising, was the one last week setting the interest rate for the next six weeks.
No interest rate hike was announced, but for the first time in the past three years, the Bank of Israel took the trouble to signal that an interest rate hike is becoming a real possibility in the short term. Its announcement contains indications that something basic in the balance of forces that dictates the interest rate in Israel has changed. Detecting this "something" does not require a deep analysis of the announcement; it is enough to read the first highlighted point: "The rise in the inflation environment continues… and it appears that the inflation environment is moving toward entrenchment within the price stability target range." The most interesting words in this sentence are "moving towards entrenchment" - more than a hint that the inflationary process that the committee is talking about is only beginning.
This phrase raised more than a few eyebrows among analysts and economists at banks and investment houses. The vast majority of them predicted before the announcement that the Bank of Israel would not raise the interest rate this year. Although many of them still adhere to that assessment, they have had to admit that the likelihood of an interest rate hike this year, and perhaps even at the upcoming committee meeting in October, has increased significantly following the announcement.
Finally meeting the inflation target
What did the Bank of Israel mean by writing "moving toward entrenchment within the price stability target range"? The Bank of Israel's inflation target is 1-3% per year, but the last time that inflation was within this target range was in 2013. Inflation in Israel was negative in 2014, 2015, and 2016 and 0.4% in 2017.
The first thing that comes to mind is the price hikes in the supermarket chains, but these price increases were not reflected in the most recent Consumer Price Index, which was flat, confounding the market's forecasts of a 0.2% rise. The Monetary Committee's analysis is based on a longer-term trend than any specific spasm of price rises.
One important component is wages in Israel, which have been rising for years. An increase in wages is an important cause of inflation. What has changed in recent months is something that concerns only a few people other than economists and statisticians.
Input prices in Israel have fallen fairly sharply in Israel in recent years. Energy prices, such as oil and coal; commodity prices, such as coffee and sugar; and other products all fell by over 3% in 2016, for example. The fall in input prices enabled manufacturers to absorb the increase in wages without raising the prices of the goods and services that they produce. In economists' jargon, this situation is referred to as a "sweet spot," and for good reason - what can be better than rising wages and falling prices?
The problem is that towards the end of 2017, the fall in input prices came to an end. Oil prices, for example, rose by a cumulative 50% from $40 a barrel to $70. Energy (excluding electricity) accounts for only 9% of the commodities index, but other marketable goods, including food products, clothing, and footwear, and overseas flights stopped pushing the Consumer Price Index down. In other words, from now on, the current pace of wage rises (3% a year) will be reflected in higher inflation, without the protective and offsetting effect of a decline in input prices.
Inflation expectations are not falling
Another of the long-term process that affected the Monetary Committee's considerations is inflation expectations, which the committee calculates by assigning weights to several sources, such as leading analysts (forecasters). As of now, the weighted figure for inflation expectations in the next 12 months is 1.2%, 0.1% higher than in the preceding month. This is what "entrenchment within the price stability target range" means.
Dispute about the rate of increase
The Bank of Israel Monetary Committee's analysis of inflation has aroused exceptional criticism among analysts at investment houses and banks who monitor the macroeconomic data. A few of them, such as Israel Discount Bank (TASE: DSCT) analyst Nira Shamir, predict an aggressive interest rate hike of up to 1% at the end of 2019. Most of them, however, believe that talk of an interest rate hike is premature. Furthermore, a considerable number of analysts believe that the Bank of Israel's announcement was unbalanced and tendentious.
Shekel fairly stable against the major currencies
No drama or game changer is involved here. What stands out is what is missing. The Bank of Israel did not take into account the most recent Consumer Price Index, in particular the housing item in it, which reflects rents.
The analysts at the banks and investment houses, the vast majority of whom still do not expect an interest rate hike this year, were surprised by the aggressive tone of the Bank of Israel's announcement. "What I regard as dramatic is the fact that the July Consumer Price Index, which was lower than the forecasts, was not mentioned in the announcement," wrote Leader Capital Markets Ltd. (TASE:LDRC) macroeconomist Yonatan Katz. "An announcement usually begins by mentioning the most recent index, especially when the Bank of Israel believes that the index shows that the market is wrong. This time, however, even though the index was 0.2% lower, it was not mentioned at all."
"Globes": It was only one index.
Katz: "True, but following this index, core inflation, which is not affected by the summer leap in watermelon prices and US President Donald Trump, fell from 1.1% to 1%. There was another figure conspicuously absent from the announcement. Rents rose by an annualized 3.3% this year up until July, but after July, this rate fell to 2.2%. The housing item is a quarter of the index, so that this figure alone reduces annual inflation by 0.2%. Furthermore, if the increase in rents goes down from around 3% to around 2%, it is very hard to see a rise in inflation."
The winning card - the shekel exchange rate
So you say that the Bank of Israel's announcement was tendentious.
"I'm only saying that all the points listed in the Bank of Israel's announcement support an interest rate hike, while all the points that do not support one and disturb its thesis are not mentioned."
Meitav DS Investment House Ltd. chief economist Alex Zabezhinsky says, "After taking a surprisingly moderate line in June, the Bank of Israel is now moving in an aggressive direction. It was expected in July that the Bank of Israel would hint that there were grounds for interest rate hikes, but the Governor of the Bank of Israel explained that inflation should first be consolidated within the target range, and that there were all sorts of conditions that had to be fulfilled. Now, they (the Bank of Israel, A.B.) say that inflation is starting to consolidate, that the drop in growth in the second quarter was temporary, that the drop in housing prices has come to a halt - these three statements together hint that the Bank of Israel is starting to think about an interest hike."
Will it happen this year?
"In my opinion, no. According to the Bank of Israel's explanations, it is true that inflation is within the target range, but it is close to its lower limit, and it is hard to say that it is 'consolidating.' I also think that the decrease in growth in the second quarter is not temporary. In addition, the Governor of the Bank of Israel has another opportunity to raise the interest rate before her term ends. In my opinion, she will need another meeting before taking a decision to raise the interest rate in order to prepare the market for this step, which can upset it."
The bottom line is that both the Bank of Israel and the analysts appear to agree that the shekel exchange rate is the joker that is likely to determine the eventual decision. "At NIS 3.60/$, it will be very hard for them," says Katz, "but at NIS 3.70/$, you are already in a different environment for inflation expectations."
Meanwhile, it appears that the Bank of Israel's hints at an interest rate hike in its recent announcement have made an interest rate hike less likely, because the market's immediate response to the announcement was a NIS 0.04/$ rise in the shekel-dollar exchange rate.
Published by Globes [online], Israel business news - www.globes-online.com - on September 3, 2018
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