Bank of Israel Takes Markets by Surprise With First Rate Hike in Seven Years

The decision to raise the lending rate to 0.25% from 0.1% is made before Amir Yaron takes over as governor

Acting governor of Israel's central bank Nadine Baudot-Trajtenberg
Eyal Toueg

In a surprise move, the Bank of Israel said Monday it was raising its benchmark interest rate to 0.25% from 0.1%, marking its first increase in more than seven years and setting off a sharp reaction from the capital and currency markets.

The central bank said it was raising the rate in response to the gradual increase in inflation to inside the government's target of between 1% and 3% annually. It also noted the economy’s “high level of demand” due to a tight labor market.

“The committee believes that the path of rising rates in the future will be gradual and cautious,” the central bank said in a statement.

On targett Israel's consumer price index - annual rate of chang

Still, just two of the 12 economists polled by Reuters had forecast a rate hike, while 10 had expected no change at the meeting, which was led by Nadine Baudot-Trajtenberg as acting central bank chief. Amir Yaron, the next governor, is due to start at the bank on December 24.

In a video statement, Baudot-Trajtenberg defended the decision to act during an interregnum between two governors.

“The committee was very aware that we are in a transition period, a period of changing governors ... but like in all previous decisions, the committee members believed decisions must be made based solely on data and economic analyses,” she said.

The share and bond markets reacted strongly. The price of the government’s 10-year shekel bond dropped 0.6% to a yield of 2.33% while its inflation-linked bond due in 2045 fell 1% to raise the yield to 1.82%. In the stock market, banking and insurance shares rallied.

The dollar and the euro both weakened about 0.5% against the shekel in late trading to 3.709 and 4.216 shekels, respectively.

“The main risk to this is the possibility of a sharp appreciation of the shekel,” the central bank said.

The Bank of Israel’s base rate has been at a record low of 0.1% since 2015 and the bank last raised the rate in 2011. The new level goes into effect Thursday.

What made the decision particularly surprising was that at the last decision on October 8, the central bank’s economists pushed back expectations for a rate increase to the first quarter of 2019 from the current quarter due to lower-than-expected inflation.

“The timing of the interest rate hike seemed somewhat puzzling,” said Gil Bufman, chief economist at Bank Leumi, noting that oil prices had slid 30% in recent weeks.

While the 0.15-point rate hike is small, it has symbolic importance because it marks the start of what could be called “normalizing” monetary policy after more than seven years during which the Bank of Israel’s base rate was near zero. In practical terms, the impact of the rise isn’t very significant.

One reason is that economic growth has been slowing, with the pace of the expansion in the third quarter coming in at an annualized figure of just 2.3%, according to a preliminary estimate by the Central Bureau of Statistics.

“In the second and third quarters, there was some slowdown in the economy’s growth rate, but current indicators of activity support the assessment that the economy is at full employment, and in particular, the tight labor market data indicate a high level of demand,” the Bank of Israel said on Monday.

However, a slowdown may well prevent the Bank of Israel from raising rates further.

In any case, an increase to 0.25% still leaves the base rate well under the inflation rate, which rose on an annual basis by 1.2% in October. For now, the real rate remains negative and monetary policy remains expansionary.
In another way, however, Monday’s rate hike is a daring act because it leaves Yaron with a fait accompli.

When the monetary committee last met a month and half ago, two of its six members voted in favor of a rate hike. This time the panel met with just five members in attendance and the balance of the vote won’t be known until its minutes are released on December 10.

The fact that the increase was approved on Baudot-Trajtenberg’s watch doesn’t mean she voted in favor.

Theoretically, the vote could have been three in favor by the committee’s outside members with the two Bank of Israel insiders – Baudot-Trajtenberg and Andrew Abir, the director of market operations – opposing. As Stanley Fischer, the former Bank of Israel governor, once noted, no central banker is likely to vote against his or her boss without a very good reason.

The Bank of Israel Law bars the monetary committee from consulting with Yaron before he officially joins the bank.

With reporting by Reuters.