The Bank of Israel took economists and the financial markets by surprise on Monday, cutting its base lending record, for the first time in five months, to its lowest since the 2009 global recession.
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The central bank said the base rate would drop a 0.25 percentage point to 0.5% in August. The bank cited a slowing economy and the risks created by Operation Protective Edge, as well as a strengthening shekel, for its move.
“It is still too early to tell the economic effects of the security situation, but the effect of security events of similar magnitude in the past decade turned out to have a moderate macroeconomic impact, up to about 0.5% of gross domestic product [in the Second Lebanon War],” the Bank of Israel said.
“The recovery from previous events was generally rapid, but the negative impact on some industries, particularly the tourism industry, is liable to last longer,” it added.
The central bank also narrowed the interest rate corridor in the credit window and the commercial bank deposit window to +/- 0.25%, from +/-0.5%. The move, in effect, doubles the impact of lower rates on the commercial banks by reducing their borrowing costs from the Bank of Israel.
Although economists had expected Bank of Israel Governor Karnit Flug to lower interest rates, few expected her to act so swiftly. A Reuters poll of 10 economists had unanimously forecast no change in the benchmark rate, which has been on hold since the bank announced a cut at its February meeting.
On the Tel Aviv Stock Exchange, the rate decision lifted share prices and caused bond prices to jump. The government’s 10-year shekel bond climbed 0.38%, cutting its yield to 2.68%, while its inflation-indexed bond due in 2023 rose 0.3%, leaving the yield at 0.57%.
The dollar strengthened nearly 0.2% to 3.4219 shekels in the early evening, while the euro advanced slightly more, to 4.5590.
The Bank of Israel has had a list of good reasons to trim the lending rate, as economic growth has cooled and the shekel has been trading at a three-year high against the dollar. GDP slowed in the second quarter, while the shekel has strengthened 0.8% since the start of July, even as fighting has raged in Gaza.
Earlier this month, Bank Leumi trimmed its GDP growth forecast for 2014 to 2.7%, from the previous 2.9%.
“Looking at the third quarter, the Bank of Israel sees a further worsening of the slowdown partly due to the continuing operation in Gaza, so it decided to bring forward an interest rate cut that apparently would take place later this year,” Yaniv Aharon, deputy head of investment at the Tamir Fishman brokerage, told Reuters.
A rate cut would spur economic growth by lowering borrowing costs while discouraging foreigners from buying shekels, because the return they can earn on their shekel holding is lower.
Unusually low inflation, as the Bank of Israel noted Monday, gave policy makers more room to cut rates without risking price hikes. Inflation was just 0.5% in the 12 months through June, and forecasts for the next 12 months of 1.2-1.3% put it in the lower half of the government’s 1-3% target range.
Nevertheless, Ofer Klein, chief economist at Harel Insurance & Finance, said Monday’s rate cut would be the last.
“The rate is similar to what it was at the peak of the financial crisis in 2009, even though we believe the economy is in better shape today than it was back then. The odds of a further reduction are very low. If the shekel continues to appreciate, we believe the Bank of Israel will step up purchases of foreign currency,” Klein said.
The Bank of Israel also has good reasons to hold rates steady, chief among them concerns about home prices and the growing mortgage burden on households – all of which could saddle banks and their borrowers with huge losses if the real-estate market were to collapse.
Over the 12 months through May, home prices increased 8.8%. Lower interest rates will make mortgages cheaper, which could spur more borrowing and buying. Amit Kaminski, CEO of AMG Mortgages, estimated that the quarter-point drop in the base rate would save mortgage borrowers 70,000 shekels over 20 years.
Reuters contributed to this report.