The U.S. Federal Reserve’s decision Wednesday to raise its key interest rate was perhaps the world’s smallest surprise. The Fed signaled it for months and the world’s financial markets prepared for the move that aims to return some sense of normalcy after seven years of zero interest rates.
European shares surged Thursday after investors considered the U.S. Federal Reserve’s move to raise interest rates for the first time in nearly a decade a sign of confidence in the world’s biggest economy. Wall Street also initially reacted positively, and if it turned lower Thursday it was over concerns about falling commodity prices. The Tel Aviv Stock Exchange also rose in response.
The strategy of Fed chief Janet Yellen and her deputy, Stanley Fischer, who cut his teeth in central banks as head of the Bank of Israel before moving to Washington, has worked at least for now.
Like the rest of the world, Israel will also be affected by the Fed’s hike. The Bank of Israel was among the last central banks to join the world of super-low interest rates, cutting its base rate to 0.1% only in August 2014. Yet Israeli consumer prices have been falling – by 0.9% in the 12 months to November.
Traditionally, Israeli short- and long-term interest rates have always been higher than America’s for obvious reasons. The country’s geopolitical situation is much less stable and Israeli inflation has been higher than America’s.
There was one exception to this rule: when the Fed raised rates to as high as 5.25% to try to stall rising home prices at a time when the Israeli rate was just 4%. History could repeat.
Since the 2008 financial crisis, many things have happened that in the past were considered impossible, such as zero or even negative interest rates prevailing for years without either significantly boosting economic growth or fueling high inflation.
As long as inflation in Israel doesn’t rise to the government’s target rate of 1% to 3% annually, the Bank of Israel is likely to maintain its expansionary monetary policy without fear of sparking inflation. An interest differential between Israel and the United States can be maintained, it seems, to some degree.
The fact that the shekel was pretty calm Thursday – the dollar gained just over 0.4% to a Bank of Israel rate of 3.895 shekels – shows that the differential can be maintained for now. The Israeli economy would easily absorb a shekel depreciation of 5% to 7%, which would be enough to improve exporters’ price competitiveness without threatening an inflationary surge.
The one place where the Fed’s rate hike is likely to have an impact in the months ahead is the Israeli bond market. Corporate bond prices are linked to government bond prices, which in turn are influenced by short-term interest rates. High government bond yields reflect expectations of higher inflation ahead, which means financing costs for the corporate world grow, too.
If inflationary pressures in the United States increase, Fed rate rises will accelerate and the Israeli corporate bond market will need to adjust quickly by falling bond prices and rising yields.
The real estate market would be affected, too, since soaring demand for homes and prices has in part been fueled by cheap mortgages. In 2007, U.S. rate rises burst the U.S. property bubble.
That kind of scenario seems remote right now. Even if the Fed raises its key rate to 1% over the next year, interest rates will still be low by historical levels. The bond market has already corrected in anticipation of this week’s rate increase. Even if there is another correction lower, or a small drop in home prices, the impact on the economy won’t be very dramatic.
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