It's time for tightening policy!

By ARIE TAL
August 20, 2009 11:53

BoI should start its tightening campaign mainly due to domestic inflation pressures.

2 minute read.



It's time for tightening policy!

arie tal 88. (photo credit: )

The central Bank of Israel (BoI) will announce on Monday its decision regarding the monetary policy for the month of September. The bank is expected to leave the interest rate unchanged at the record low level of 0.5% for a sixth month. The main considerations behind the decision would be the uncertainty regarding developments in the global economy, the fact that major central banks keep interest rates low, and estimations that output gap and unemployment will moderate price pressures. However, according to market indicators, the current benchmark rate is not compatible with the current situation of Israel's macroeconomic environment. BoI cannot wait too long as other central banks and should start its tightening campaign mainly due to domestic inflation pressures. Continuous Rising Prices Supports Tightening In the past 12 months, the Consumer Price Index rose by 3.5% despite the global recession and the negative implications on the export sector. In the past 5 months prices rose by almost 4% primarily as a result of rising housing and energy prices which are estimated to keep rising in at least the next six months. Economists forecast that the inflation over the next 12 months will range between 2.5% and 4%, while the capital market priced even a higher level of 4.2% a week ago. In the past few days, the inflation expectations that are derived by the bond market have decreased from 4.2% to 2.5% (12 months forward) due to estimations that BoI will increase rates sooner than previously expected. Additional Factors: Recent economic indicators support the assessment that the domestic economy is emerging from the recession and relatively immuned to the external shocks. Hence, BoI should be less expansionary driven. Israel's economy expanded 1 percent in the second quarter and expected to rise also in the current one. The composite state-of-the-economy index rose by 1.2 percent in July - second month in a row, after declines in the index every month since June 2008. The rise in the index this month resulted from an increase in economic activity in all categories, and in particular from steep increases in manufacturing production and trade and services revenue. Additionally, the Israeli Employment Organization reported a decrease of 2% in unemployment claims in July. Need to raise, but will keep unchanged: The Market is pricing in the probability of a beginning of rate hikes by the end of the year. Nonetheless, some economists estimate that BoI might and should raise the benchmark rate already on coming Monday due to the reasons mentioned above. The uncertainty is high. Increased confidence that the domestic recession is ending clearly is not enough to execute a shift in monetary policy. First, there continues to be considerable uncertainty about the strength of the recent trends. Second, banking lending remained relatively weak. And if growth slows again inflation might fall. BoI announced recently that it expects increases in the CPI (consumer price index) in the months of July and August, mainly because of the increases in VAT (value added tax) and government-supervised prices, but the bank also predicted a decrease in inflationary pressures later this year. Therefore, the governor Stanley Fischer might hold rates at record low for at least another month and examine the economic developments and prices dynamics. The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House and also a regular writer for several leading financial papers and websites


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