The Bank of Israel's low interest rate is creating an asset bubble in the real estate market as investors are driven to buy stocks and apartments, Excellence Nessuah Investment House said Wednesday. "Israel is unique in having relatively high levels of inflation - 4.2 percent projected for 2009 - coupled with a very low central bank policy rate (0.50%). This combination is sowing the seeds of a major asset bubble. The effect of the nascent bubble is evident in the real estate market, where the housing element of the CPI has continued to rise, despite growing unemployment and a shrinking economy," said Terence Klingman, senior analyst at Excellence Nessuah Investment House. Klingman noted that Zvi Eckstein, Bank of Israel's deputy governor, recently remarked on this trend in real estate prices, though he said the bubble has spread to other assets, such as certain corporate bonds, and even government bonds where prices are "highly elevated." In such a scenario the central bank finds itself squeezed between two uncomfortable alternatives: let the bubble gather momentum, or raise interest rates to deflate the emerging asset bubble, according to Klingman. "The main lesson from the current crisis is that it is dangerous to let asset bubbles developed unchecked, yet the Bank of Israel might be wary of raising rates so as to avoid the risk of plunging the economy into a prolonged recession (like Japan in the 1990s)," said Klingman. "Obviously, if the central bank chooses not to raise rates, it risks the unwinding of a big asset bubble at some indeterminate future date. On the other hand, a rising interest rate environment will increase the debt service burden of borrowers and might impact creditworthiness in the medium term." He added, though, that looking ahead to the next six to 12 months, both scenarios would spell good news for the banks. "Under both scenarios the big Israeli banks will return to double digit return on equity by the end of 2009," said Klingman. "If the Bank of Israel chooses not to react to the asset bubble, loan loss provisions at the Israeli banks are going to decline very rapidly and will end up below 0.5% by the end of 2009. If the BoI begins to raise interest rates, interest margins will rapidly normalize from depressed levels and the banks will reap windfall accounting profits on CPI derivatives."