In the wake of this week's decision by the Bank of Israel to cut its benchmark interest rate to 3.5 percent, global investment houses are warning the central bank to halt its policy of monetary easing amid signs that inflationary pressures are building up beneath the surface. Local houses, meanwhile, are wary that further monetary easing could boost capital market activity, putting financial stability at risk and strengthening the shekel even further. "While CPI inflation is likely to continue its downward path in the coming months, we believe that the Bank of Israel will take a break from its monetary easing, as some inflationary pressures have been building up in the economy," said Turker Hamazaoglu, emerging markets strategist at Merrill Lynch in a research note. Hamazaoglu added that Monday's decision left the door open for further cuts as the central bank said no inflationary pressure was yet evident and that inflation would return to its target range of 1% to 3% in the first half of 2008, if the shekel remains at current levels. "Despite the dovish wording, we attach this flexibility as a buffer for credibility in case of further shekel strength," said Hamazaoglu. Similarly, Serhan Cevik at Morgan Stanley noted that although inflation would remain low in the near future, risks were now on the upside on the back of robust domestic demand, which has created hidden inflation. Consumer price inflation moved from 3.8% in April 2006 to negative 1.3% in April this year. "According to the Bank of Israel's estimates, the 'domestic' component of the CPI recorded a 4% year-on-year increase in the first quarter of the year - even above the upper bound of the target range, whereas the 'imported' component (including currency-linked items and energy prices) showed a 4.6% drop," said Cevik. "The continuing pace of above-trend growth in domestic demand is great news, but also means that the Israeli economy will keep experiencing inflationary pressures stemming from a 'positive' output gap." Cevik pointed out that the strength of the global economy and accommodative monetary conditions in Israel had pushed GDP growth beyond the trend growth rate and led to higher inflation excluding the exchange rate pass-through effect. In the first quarter of this year, GDP grew by an annualized 6.3% and business product by 6.5%. At the same time, Cevik predicted that even though fundamental improvements in the economy would still support the shekel's valuation, the currency was likely to stabilize around the current level and have a diminishing influence over domestic prices. "This is why we have argued that underlying pressures resulting from sustained growth in domestic demand will start dominating inflation dynamics," he said. Meanwhile, Gil Bufman, chief economist at Bank Leumi, challenged the effectiveness of the continuation of the central bank's monetary policy of moderate easing to preserve financial stability. "We don't see much effectiveness of this continued policy under the current market conditions and the existing risks to financial stability because of the impact of interest rate cuts on high activity on the share and bond markets," said told clients. "Continuation of this policy of moderate interest rate cuts will only increase the risk of instability over the coming year." Shlomo Maoz, chief economist at Excellence Nessuah, who over the past year has urged the central bank to drastically cut interest rates, now warns that any interest rate cuts below 4% would only further strengthen the shekel under current market conditions. "The Bank of Israel should have cut interest rates aggressively from the beginning of last year but now is not the right time," said Maoz. "Under the current market conditions lowering interest rates will further increase capital market activity, which in turn is bound to strengthen the shekel."