BoI likely to keep raising interest rates

Inflation is expected to be affected by soaring housing prices (up 17.5% over the last 12 months) and strong growth figures.

By YANIV HEVRON
58_Stanley Fischer (photo credit: Bloomberg)
58_Stanley Fischer
(photo credit: Bloomberg)
The Bank of Israel decided to raise its key lending rates for March by 0.25 percent to 2.5%, increasing interest rates for the second consecutive month.
The decision was not surprising because inflation expectations continue to soar (3.5% – the highest rate in the past seven years), following strong growth figures for 2010.
The most important part of the rate announcement was what was missing from it.
For the first time ever, the central bank did not publish inflation expectations for the next 12 months, suggesting that Bank of Israel economists believe this year’s inflation will be well above the official target.
Inflation is expected to be affected by soaring housing prices (up 17.5% over the last 12 months) and strong growth figures. We believe, therefore, that Bank of Israel Governor Stanley Fischer will continue to increase rates and that the pace of rate hikes will be higher than previously anticipated.
The most dramatic development was the surprising growth figures for 2010, released by the Central Bureau of Statistics, showing that the economy expanded by a phenomenal 7.8% in the fourth quarter of 2010.
The fast growth rate, usually seen only in emerging markets such as China and India, was dominated by a sharp increase of 9.8% in private consumption.
It has been clear for the past several weeks that inflation expectations are rising above the official target. Expectations have been fueled by a new acceleration in housing prices and commodities. The main reason for the rise in inflation expectations is the inability of the Bank of Israel to sharply increase interest rates to curb inflation.
The central bank has been following the markets and has started taking steps together with the Finance Ministry to ease pressures for the shekel’s appreciation. Nevertheless, expectations continued to soar, further extending the pressure on the Bank of Israel to accelerate the pace of rate hikes.
The consumer price index for January rose 0.2%, well above expectations and sharply higher than the average CPI in January over the past five years, which was a negative 0.4%.
Housing prices continue to rise and a family now needs 131 monthly salaries to buy an average apartment.
One of the most interesting sectors in the market is the banking sector. After a sharp increase in the price of bank shares at the end of last year, the banking sector seemed to lose momentum this year. This was attributed to foreign investors who appeared to have lost their appetite for Israeli financial institutions and preferred to invest in banks abroad, which are traded at lower prices.
Even an average dividend yield of some 5%, rising interest rates and higher inflation, which are expected to positively affect the banks, did not help. Egyptian protests and rising geopolitical uncertainty further increased this trend, as foreign investors took a step backward and lowered their exposure to the local market.
Recently, it seemed as if local investors were using the opportunity to increase their holdings in the banking sector, and bank shares gained an average of some 5%.
In the debt market, the spread of corporate bonds continued to decline. The average spread declined by nine basis points in one week, completing a decline of 37 points since the beginning of the year.
We believe the rise in government-issued bonds will eventually lead to a shift from corporate bonds to state bonds, and investors should therefore consider lowering their exposure accordingly.
Yaniv Hevron is the head of macroeconomics and strategy at Excellence Nessuah investment house.