Bank of Israel Takes Markets by Surprise With Interest Rate Cut

Central bank cites moderate rate and growth projections to explain cut, but analysts attribute it to the appreciation of the shekel.

In a move that took the markets by surprise, the Bank of Israel on Monday lowered its base lending rate by 0.25 of a percentage point to 1%.

It was the first time the bank had lowered its base lending rate since last May, just weeks before Stanley Fischer was due to step down as governor. Since then the post has remained unfilled, with Karnit Flug serving as an interim governor. Analysts had not expected her to adjust the interest rate until Fischer’s official successor takes office.

The bank’s Monetary Committee cited a host of reasons for the decision, among them the fact that inflation and economic growth are both projected to remain moderate. While rising home prices might have prompted the bank to retain rates at current levels or even raise them, the committee expressed confidence that the measures taken by the bank to contain mortage demand would serve the purpose.

Economists, however, attributed the decision mainly to the appreciation of the shekel and the decision by the U.S. Federal Reserve last Wednesday to continue its quantitative easing program.

"Without the appreciation of the shekel, it would be reasonable to assume that the interest rate would still be at 1.75%,” said Ayelet Nir, chief economist and strategist at Psagot Investment House. It was likely that the interest rate would remain unchanged in the coming year, as the Fed winds down its easing program and the gap between bond yields in the U.S. and Israel is reduced, she said.

Joseph Fraiman, CEO of the Prico Group investment house, shared Nir's assessment of the influence the appreciating shekel had on the bank's decision, but he said further steps needed to be taken to protect the economy.

“The Bank of Israel decided to return to a policy of leading instead of being led, and reduced the profitability of gambling on the exchange rate,” said Fraiman. Nevertheless, he said, “The Bank of Israel's action cannot be an isolated act. A broader step is needed to ensure the profitability of exports and prevent the local market from being flooded by imports.”

The shekel has gained 6.7% since the beginning of the year, a trend that threatens to undermine the price competitiveness of Israel’s exporters. Since the Monetary Committee’s previous rate decision last month, the shekel has gained 1% against the dollar, reaching a two-year high on Friday.

The dollar strengthened on Monday, adding 0.3% to a Bank of Israel rate of NIS 3.5150. In late trading it appreciated further to NIS 3.5282.

Figures presented at the committee meeting on Monday showed that inflation over the past 12 months had had been 1.3%, near the bottom of the government's annual inflation target of 1% to 3%. The outlook for inflation also remains moderate, the bank noted, with private forecasters seeing prices rising 1.9% on average and bond yields pointing to even lower inflation of 1.4%.

Meanwhile, the Bank of Israel’s research department said on Monday it was lowering its projections for economic growth this year to 3.6% from its previous estimate in June of 3.8%. However, the bank said gross domestic product would grow 3.4% in 2014, increaing its earlier projection of 3.2%. Inflation will be 1.9% over the next 12 months, it said.

At the same time, exports have continued to fall, as global trade stagnates and consumer spending has moderated. Government expenditure is expected to grow at a slower pace in 2014 and new tax hikes will go into effect at the beginning of the next year, crimping economic growth. The bank also noted that the global picture pointed to a possible slowdown in recovery of the developed economies, citing lower forecasts this month from the World Trade Organization, the Fed and the Organization for Economic Co-operation and Development.

Monday’s interest rate cut elicited some concern in the market about the Bank of Israel’s ability to influence the exchange rate and the economy going forward.

“The Bank of Israel is using the last tool available by lowering the interest rate,” said Assaf Shaul , Alfa Platinum Mutual Funds chief investment officer. “This means that it will be much harder for the next governor. The interest rate weapon will have been completely exhausted and the next stage it will have to be more creative.”

Michal Fatal