Inflation Expectations: Exaggeration or coming realization

There are still several economic risks and policies that might have a significant weight on economic growth.

arie tal 88 (photo credit: )
arie tal 88
(photo credit: )
The Central Bureau of Statistics will publish tomorrow (Friday, 14.08.2009) the Inflation report for the month of July. The consumer price index (CPI) is expected to rise by 0.8-1.1 percent compared to the previous month, and 3.3 percent in the past 12 months. Whereas In June the cost of living increased by an annual rate of 3.6 percent, mainly due to a rise of 17 percent in housing cost. July Inflation Report: high index affected by government's policy Generally, prices tend to moderate during the summer time due to seasonal reasons. However, this summer the inflation environment will be a bit different. The main driver of the increase in July is the hike in Value Added Tax (VAT) from 15.5% to 16.5%. A rise in gasoline prices, a surcharge on residential water usage, increase in commodities and agriculture products will push the CPI further up. A rise is also expected in housing costs, despite a 3.2% depreciation of the dollar against the Shekel in the relevant period. On the opposing side, the parameters that should curb the increase of the cost of living are the followings: a drop in clothing and footwear prices due to an end of season sales, a reduction in electricity rates and a decline in dairy products. August, September CPI Reports: August - 0.55%, September - 0.2% In August the CPI is expected to go up by 0.4%-0.7%, and in the month of September by 0.1%-0.3%. The increase in prices will be affected again by the water surcharge, VAT, and fruits and vegetable prices. Another factor that will support a rise in the CPI is the green car taxation on new cars. The main factor that would partly offset the price increases is a continuous decline of clothing and footwear prices due to seasonal reasons. Short to Medium Term Forecast: divergence between BoI and Market The 2nd quarter inflationary report of BoI (Bank of Israel) indicates that the Bank still believes at only 1.6% inflation level during the coming year. The BoI expects the inflation level to enter into its target range, 1%-3%, despite the expectations of relatively high indices during the forthcoming period, which would be affected by the initiated price hikes that were mentioned above (water surcharge, VAT). As oppose to BoI estimates, economists and market participants forecast higher inflation. The annual inflation rate in 2009 is expected to be above the top limit of BoI's inflation target, somewhere between 3.2 and 3.4 percent. However, inflationary pressures are expected to weaken in the next 12 months to 2.85 percent as a result of the continued global economic slowdown. Inflation Expectations: higher & higher, what to do? Inflationary expectations derived from the capital market continued to rise across the curve since the beginning of the week. The inflation expectation of one year ahead is now 4.25% compared to 3.85% last week and 3.75% two weeks ago. Moreover, according to the bond market, inflation will remain above 3 percent - the top limit target of BoI - in the next 7 years. This is too high, too exaggerated. There are still several economic risks and policies that might have a significant weight on economic growth. Interest rate will increase soon, taxes will be raised in the medium term, regulation and deleveraging will also play a significant role, and the international trade sector still in depressed levels despite the recent recovery. Bottom line, Inflation expectations in short and medium term durations might be overpriced. As the short and medium term inflation linked bonds reflect negative real yields and/or inflation expectations high above the top limit target of BoI, there is no justification to invest in the relevant bonds during this period. 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