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Flouting all expectations the Bank of Israel yesterday announced a rate hike for August. The central bank interest rate will rise by 0.25% to 4%, which confounds the forecasts of nearly all capital market analysts. By and large the capital market community had predicted that Governor Stanley Fischer would elect to sit tight following the unexpectedly low increase in consumer prices last month, which ostensibly gave him extra time to keep the interest-rate environment low.

The interest increase indicates that Fischer is still worried about inflation despite the low consumer price index in June. The index, which tracks a basic basket of consumer items, rose by only 0.1% last month, though analysts had expected an 0.5% increase. Even so, most analysts expect the central bank to miss the government-set inflation target, which is 1% to 3% for the year.

In the wake of the governor's decision, commercial banks will raise their interest rates to the public, including on account overdrafts, by 0.25%.

Some of the Bank of Israel top management came out in support of keeping interest rates at 3.75%. August will be the fourth consecutive month that the central bank has raised interest in increments of 0.25%.

In yesterday's announcement, delivered in the evening, the Bank of Israel said that the governor decided in favor of the increase to further the bank's policy of maintaining price stability. It also has its eye on economic growth, the central bank said.

However, in each of these areas - price stability and economic growth - the picture is mixed, the central bank notes. During the last twelve months the CPI has risen by 4.8%.

Inflation expectations among analysts and implied in the capital market regarding the next twelve months are around 3%, which is the upper limit of the inflation target range set by government.

On the other hand, the core CPI index - excluding fuels, food, and fresh fruits and vegetables - rose by 1.9%, close to the midpoint of the target range.

The surprisingly low CPI in June of just 0.1% led to a marked fall in twelve-month inflation expectations. In addition, commodity and energy prices have recently gone into retreat, which will serve to moderate inflationary pressures in Israel, say analysts.

Moving onto Israel's economic growth, the Bank of Israel believes that Israel's gross domestic product is close to its potential. However, import and export figures for June 2008 indicate that the economy continues to expand. This theory is also supported by figures for retail chain sales.

On the other hand, the Bank of Israel's Companies Survey and the May and June composite State of the Economy indices indicate that the pace of growth - while still positive - is slowing down.

On the basis of these two conflicting factors, the Bank of Israel decided to raise interest rates "to support the return of inflation and inflation expectations to around the middle of the target. The return of inflation to the target range is essential as a basis for sustainable growth."

Response to the news has been mixed. The chairman of the Manufacturers Association economics committee, Ori Yehudai, said that a continued increase in interest rates paves the way for economic recession. The Director of the Federation of Israeli Chambers of Commerce, Uriel Lynn, however, said that he supported Fischer's decision because the state of the economy demands fighting inflation without jeopardizing the exchange rate.

A senior source in the industrial sector said the rate hike reflects the central bank's lack of trust in the government's budget policy and would cause many small businesses to fail.

Analysts said yesterday that although net interest rates are relatively low - they still predict that the central bank will keep interest rates unchanged through the end of the year.