With inflation rates stabilizing, the shekel softens, and with domestic demand on the rise, analysts warn of underlying inflation risks, reinforcing expectations that cuts in short-term interest rates have come to an end.
"The recent selloff in the shekel versus the US dollar, the stabilization in the year-on-year rate in May suggests that inflation has reached its bottom, and will actually increase from now on," said Citigroup analyst Jean-Francois Mercier in a research note. "The Bank of Israel's projection that inflation will return within its 1 to 3 percent target some time in the first half of 2008 gains credibility, and this reinforces our expectations that short-term rates have troughed, and that the next move will be up, though probably not before late 2007."
The May Consumer Price Index remained unchanged at 99.4, against market consensus, which had predicted that it would fall by 0.2%, leaving the year-on-year inflation rate unchanged at minus 1.3% - the first time since January that it has not declined.
In their analysis of the May CPI, Citigroup pointed out that the determinants of rate showed that Israel's housing market was "de-dollarizing" itself.
"The decline in rental inflation is increasingly "decoupling" from exchange rate developments. This suggests that as the dollar falls, an increasing number of landlords are either raising their dollar rent or denominating the rent in shekels - this maybe a sign that this sector is gradually de-dollarizing," said Mercier.
The Bank of Israel this week published inflation expectations for the next year, which rose to 1.2% in the last 30 days, from 0.7% in May and 0.5% in April. Expectations for the next two years rose from 1.3% in May to 1.7%. In the central bank's survey of private forecasters, inflation expectations for the next 12 months also rose from an average of 1.2% year-on-year in May, to 1.4%.
Cerhan Cevik, an analyst at Morgan Stanley, warned that the shekel's appreciation against the dollar was no longer enough to curb inflationary pressures.
"If we look beyond the headline figure, there are clear signs of higher inflation in the Israeli economy - hidden behind the veil of currency appreciation," said Cevik. "The deflationary power of currency appreciation is coming to an end and "domestic" factors will become far more influential over inflation dynamics. With the stabilization of the exchange rate and above-potential growth in domestic demand, we expect a steady increase in inflation."
Cevik added that inflation would be determined in part by Israel's narrowing output gap. "After expanding at an annualized rate of 6.3% in the first quarter, Israel's economy shows no sign of economic slowdown, if anything, it is likely to record even stronger readings, as domestic demand gains momentum," said Cevik. "The Israeli economy is certainly expanding at a rate that keeps narrowing the output gap, especially as we witness a slowdown in productivity growth."
Assuming a steady increase in inflation and considering the delayed effect of monetary easing, the investment bank concluded that interest rates at current levels underestimated inflation risks.
"Thanks to technical (but temporary) deflation, Israel has decoupled from the rest of the world," said Cevik. "We are not obsessed with interest rate differentials, but pricing perfection not just in economics but also in geopolitical affairs sets the stage for higher volatility."