Strategist: No need for steep interest rate raise

Actual inflation is still near the upper limit of the central bank's 1% to 3% price stability target for the year, and may accelerate in the coming months due to seasonal factors and high energy prices.

March 8, 2006 07:35
1 minute read.
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Israel's strong international position and an undervalued shekel provide no justification for "aggressive" interest rate raises by the Bank of Israel in the short-term, but rather a "gradual return to normalcy," Morgan Stanley said in a report released Tuesday. The firm predicted the central bank would raise the interest rate by "at least" one half of a percentage point above the current 4.75 percent rate over the coming months. Its next decision on rates will be released March 27. "Structural reforms and fiscal consolidation allow the Bank of Israel to experiment with keeping real interest rates at a lower plateau compared to the past," Morgan strategist Serhan Cevik told clients. But, he said, even an apparent "new paradigm" of relatively low interest rates would not justify keeping interest rates low over an extended period because that would be "an obviously accommodative monetary policy," bowing to market pressures. Significant differences between the interest rate and the market's tolerance level could require an "abrupt adjustment" down the road, Cevik cautioned. And, like it or not, he reminded, both imports and Israel's dollar-based housing market mean that fluctuation in the shekel's rate against foreign currencies greatly influences both actual inflation and inflationary expectations. Fundamental factors, he said, point to contraction in the gap between gross domestic product (actual output) and an economy's potential level of output, compounding inflationary pressures. Reviewing macroeconomic factors, Cevik noted that "There is no indication of a sharp slowdown in economic activity. In fact, all the indicators point towards the continuation of above-trend output growth." Prevailing trends, he believes, support his prediction of 4.5% real GDP growth for 2006, which could also help narrow the output gap despite slack in the labor market. Actual inflation, he noted, is still near the upper limit of the central bank's 1% to 3% price stability target for the year, and may accelerate in the coming months due to seasonal factors and high energy prices. Nonetheless, he expects inflation will remain close to the target range's upper limit in the first half of the year. He partly attributes the past year's rise to the delayed effect of higher energy prices and a weak shekel. Though international competition in certain markets, such as clothing and footwear, have helped keep inflationary pressures in check thus far, core price indices are likely to begin rising due to the accumulated effect of relatively low interest rates, Cevik predicted.

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