Fischer takes markets by surprise with unexpectedly big interest rate hike
The Israeli growth engine has powered the economy through wars, a global financial crisis and turmoil in the Middle East, but Stanley Fischer, the country’s central banker, is now determined to get a grip on the controls.
Fischer took economists and the financial markets by surprise late on Monday by lifting the Bank of Israel’s base lending rate 0.5 percentage point to 3%. While the rate is low by historical standards, the bank has doubled the rate in just nine months. More hikes are likely to come, the economists said.
Israel’s economy grew by 4.6% last year, capped by a 7.7% annual rate in the final quarter of the year. Even as oil prices are climbing and regional unrest raises political uncertainty for the country, there has been little sign that the expansion is cooling very much. The Bank of Israel’s S index, a barometer for economic activity, rose a sharp 0.4% in February.
But the heady rate of growth has begun to show its dark side in higher consumer prices, a development of major concern for a country with a long and bitter memory of hyperinflation. The consumer price index (CPI) rose 4.2% in the 12 months to February, well over the bank’s target range of 1% to 3%. Economists see inflation slowing over the next year, but not enough to bring it back into the range.
“He made a mistake. He didn’t understand the significance of the inflationary danger,” Michael Sarel, head of research at Harel Group, told The Media Line. “It’s a step that was very much needed. It’s a pity he didn’t act earlier.”
Until Monday, Fischer had been steering interest rates higher, but only gradually, as he tried to balance his mandate to contain inflation with the need to prevent the shekel from appreciating by boosting interest rates much higher than in other developed economies. A stronger shekel hurts export, a key sector for the Israeli economy, by making
costs measured in dollars higher.
Except for a brief dip in 2008, Israeli gross domestic product has grown between 4% and 6% annually since 2003. The expansion has proceeded even as the world economy was reeling from the fallout of the U.S. housing market and during wars with Hizbullah in Lebanon and Hamas in the Gaza Strip.
With the interest rate less than inflation and likely to remain so for some time, Fischer acted too slowly in raising interest rates, most economists say. Monday’s unusually sharp rate increase marks an “admission of failure to some extent,” Citigroup Global Markets said in a report on Tuesday. It said investors are now looking for rates to be pushed up to as much as 4.5% by the end of the year, a forecast it labeled as “excessive.” Most economists and the central bank itself said it would likely be about 4%.
But Citigroup and others said Fischer may now have changed his strategy and wants to rely on a stronger shekel to mitigate the inflationary impact of higher global prices for oil and other commodities. If so, the Bank of Israel has some very early indications that it’s wish is being granted: The shekel appreciated on the back of the rate hike, with the official rate set at 3.525 to the dollar on Tuesday, close to its strongest level in 27 months.
The Israel Manufacturers Association, which represents the country’s biggest industrial companies, warned on Tuesday that if the shekel appreciates to 3.5 to the dollar, companies will lose some $2.9 billion in export sales, equal to about 6.6% of the country’s exports. They will even be hurt in the domestic market because the price of imports will fall.
The Bank of Israel itself assumes that every 10% appreciation in the exchange rate after inflation causes a 2% drop in exports, with a more adverse impact on profit margins.
Economists said the latest rate hike and the ones expected over the next months would certainly put a brake on economic growth but, with the economy in hyper drive, Fischer has room to maneuver without causing damage. Merchandise exports jumped at a near 30% annual rate in the December-February period, according to Israel’s Central Bureau of Statistics.
“The more significant impact is on both the mortgage rates for floating rates loans which will become more expensive,” Jonathan Katz, Jerusalem-based economist at HSBC Holdings, told The Media Line. “It will have a damping effect on housing demand as well as consumer demand because those who are making interest payments will see their disposable income decline.”
For the Bank of Israel anything that would help calm the local real estate market would be welcome. Home prices, which aren’t included in the official CPI but factor into household costs all the same, have shot up by 16.3% in the 12 month to February, even after the central bank took steps to discourage people from taking out mortgages.
In January alone, home price rose 0.9%, slowing only marginally from a 1.3% monthly pace in November and December. Jean-Michel Saliba, a Bank of America/Merrill Lynch economist who covers the Israeli economy, said Fischer would probably have to do more to address the problem of home prices.
“Average mortgage rates are increasing but are still close to historic lows. More macro-prudential tools may be needed along with measures on the supply side,” Saliba told The Media Line. “The export sector is likely to bear the pain of the shekel’s strength.”