Even after posting GDP growth of 6.3% in the first quarter of 2007, in annualized terms, Israel's economy shows no sign of slowing down, says Morgan Stanley analyst Serhan Cevik. On the contrary, growth could accelerate down the line this year, if domestic demand continues to climb. That is especially true of private consumption, which increased by 11.8% in the first quarter of 2007, he says.

But inflation worries him. He has been writing for some time that there are inflationary pressures beneath the surface, that were hidden by the shekel's appreciation against the dollar and the Israeli penchant for "dollarization" - linking prices to the dollar. This has remained common practice, mainly in the housing but in other sectors too, since the days of hyperinflation in the early 1980s.

In this latest review, Cevik warns that the shekel?s appreciation against the dollar is no longer enough to curb inflation pressures. Israel's official inflation rates are a technically distorted view of the real picture, which is that inflation is there.

Even prices quoted in dollars have risen, which isn't surprising given the intensity of domestic demand, he observes.

Inflation will be determined in part by Israel's narrowing output gap: "The Israeli economy is certainly expanding at a rate that keeps narrowing the output gap, especially as we witness a slowdown in productivity growth," Cevik writes.

Meanwhile, he sees the corrections in the capital markets as a sign of normalization, and warns that the corrections - mainly in the long-term bond market - is not over.

Moving onto the exchange rate, Cevik notes that the low level of interest rates leads players to underestimate inflation risks. Even though Israel's economic fundamentals should continue to support the shekel, even below 4.10 to the dollar, he says, the  technical effect of the exchange rate will disappear and domestic factors will come to dominate more. In short, inflation will start creeping up again.