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The Bank of Israel (BoI) has officially begun its monetary tightening campaign by the traditional standards. BoI Governor Stanley Fischer announced on last Monday that the bank had decided to increase the benchmark rate up to 0.75% from 0.5% after keeping it unchanged for the previous four months.
According to a survey that was conducted by Bloomberg, 10 out of 12 economists estimated that the BoI would keep interest rates unchanged because of the following reasons: continuous uncertainties about the future of real global economy, medium probability of descending inflation and concerns over additional strengthening of the shekel against the dollar. Nonetheless, the fear of an inflation outbreak and recent published growth indicators led the governor to act "politically incorrectly".
However, Fischer proved once again that he is not concerned with politics when it comes to price stability and economic risk. Overall, when taking all parameters into account, Fischer did the right thing this time, after wrongly slashing the benchmark rate too aggressively at the end of 2008 to 0.5% - a level which was incompatible with the domestic economic environment at that time and which added significantly to the rise in prices.
Inflation Tipping the Scale
The semi-surprising announcement had followed high inflation data in the past few months. In fact, since the beginning of 2008, the average annual inflation was above 4%, while in the past year, the cost of living has increased by an annual rate of 3.5% - above the BoI's target range of 1-3%.
The sum of the next three inflation reports is estimated to add 0.8-1.2% to the accumulated inflation. In the next 12 months, the direction of prices depends mainly on the domestic demand, the pace of recovery of the global economy and its effect on commodity price, and the Israeli export sector. Most chances are that inflation will moderate due to the lagged impact of the tightening policy and the slow and gradual global recovery.
Market Expects Rising Rates and Moderating Inflation
Inflation expectations, which are derived from the government bond market, reflect an inflation of 2.2 percent in the next 12 months compared to 4.5 percent two weeks ago. The sharp decrease is attributed to forecasts that the interest rate will keep rising in the short-term. The market expects that the interest rate will rise by one percent in the next 12 months.
According to global developments and prices dynamics, the likelihood of continuing rate hikes increases. The BoI is likely to raise rates gradually to 1.5% by the end of the first half of 2010, and 2% by the end of the next year.
The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House and also a regular writer for several leading financial papers and Web sites