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(photo credit: Ariel Jerozolimski)
The Bank of Israel unanimously raised September interest rates in an effort to bring inflation to within the target range and to continue to support the recovery of economic activity.
"The most recent data on real activity in Israel strengthen the assessment that there has been a turnaround, although there is great uncertainty regarding the expected rate of growth," according to the minutes of the interest-rate decision that took place August 24, which were released Monday.
"Interest rates of the leading central banks around the world are expected to remain unchanged until the end of the year and possibly even to the middle of 2010. However, unlike in Israel, inflation in those countries is expected to remain low both this year and next," the report said.
The Bank of Israel was the first central bank to raise the key lending rate, by a quarter point to 0.75 percent on August 24, which was the first time it had been raised since July 2008.
In the discussion of the interest rate for September, all four members of the central bank's monetary forum recommended that the governor increase the interest rate. Three of them recommended an increase of a quarter of a percentage point, and the fourth recommended an increase of half a percentage point.
Participants in the forum said the latest indications showed that Israel's economy had switched from rapid contraction to moderate growth in a wide range of industries. Nevertheless, they said activity was still at a low level, that the output gap was expected to continue widening and that unemployment was expected to increase in the next few months.
"There is great uncertainty with regard to the extent to which the recovery would endure," the report of the minutes said.
Much concern was raised that the US economy, which greatly influences Israel's exports, would recover more slowly than the currently prevailing market assessments.
"While the local economy has already started to recover in the second quarter, we believe GDP growth is likely to be more moderate than initially expected, and the recovery should be much more subdued than in some of the other emerging-market economies," Haim Israel, research analyst at Merrill Lynch, said in a report Monday.
In addition, participants in the interest-rate meeting discussed the issue of inflationary pressures. Inflation in the previous 12 months was above the upper limit of the target range of 1% to 3% despite the low level of real activity.
The participants said since some of the increased rate of inflation was due to one-off factors, its degree of persistence was expected to be low, while at the same time, the existence of the output gap and the relatively high rate of unemployment would act to moderate inflationary pressures.
"Short-term real interest in Israel was one of the lowest in advanced economies, and in most of those countries inflation next year was expected to be low," stated the report.
Meanwhile, Merrill Lynch's Israel said inflation in Israel was slow to come down, while tax increases create rigidity.
"This is also likely to leave the Bank of Israel with few alternatives, and we expect interest rates to increase by the most in the coming year and a half," Israel said. "As inflation is likely to stay above 3% until the second half of 2010, we see policy rates at 1.5% and 3% at the end of 2009 and 2010 respectively."
Merrill Lynch expects further appreciation of the shekel to continue hurting exporters. On Monday, the shekel weakened slightly by 0.4% to 3.75 per dollar.
"Israel is likely to be relatively handicapped by its large exposure to the US dollar," Israel said. "As a small, open economy, where some 40% of exports are destined for the US (accounting for 17% of GDP), a weaker US dollar together with softer global demand is likely to hamper corporate profitability. This is especially true in Israel's hi-tech sector, which records revenues in US dollars yet carries costs in shekels."
Merrill Lynch currency strategists expect the shekel to continue to strengthen against the dollar and project the shekel-dollar exchange rate to reach 3.40 by the middle of next year and 3.45 at the end 2010.