Bank of Israel Cuts Base Rate for Second Time in Two Weeks

Surprise move comes as the central bank battles to weaken the shekel against the dollar.

The Bank of Israel signaled Monday that the war against the strong shekel isn't over, cutting its base lending rate by a quarter of a percentage point for the second time in two weeks to 1.25%.

The decision came as a surprise to the financial markets and economists, who had expected the central bank to keep the rate unchanged for June. Only six of the 13 economists polled by Reuters had predicted a rate cut, while seven had forecast no move.

In explaining its move, the Bank of Israel cited the need to "weaken the forces for appreciation of the shekel." It noted that the past two months had seen many of the world's central banks lower rates. A summary of the monetary committee's deliberations showed concerns that the process wasn't over.

"The expansionary policy of the central banks in major advanced economies is expected to continue in the coming year as well," the Bank of Israel said.

Bank of Israel Governor Stanley Fischer, who is scheduled to step down at the end of June, has devoted his final days in office to stemming the appreciation of the shekel. He is concerned that a strong shekel will damage the competitiveness of Israeli exports and weigh on the economy.

Two weeks ago, in a move reminiscent of Fischer's rapid-fire action at the start of the global economic crisis in 2008, the central bank made an unscheduled quarter-point rate cut. In tandem, it announced it would buy $2.1 billion in foreign currency through the end of 2013 in a bid to reverse the shekel's appreciation against the dollar.

Foreign currency purchases create demand for dollars, while interest rate cuts make it less attractive for investors to hold shekels.

Analysts said Monday's rate cut underscored the extent to which the Bank of Israel had relegated inflation-fighting – its traditional first priority – to second place in favor of ensuring economic growth.

"The Bank of Israel rate reduction illustrates yet again that the main problem is low growth over the next year and the strong shekel that threatens to hurt growth even more," said Ilan Artzi, chief investment manager at Halman-Aldubi. "The Bank of Israel doesn't seem worried at all about inflation for the foreseeable future."

The Bank of Israel Monday described the inflation environment as "moderate," noting that the consumer price index had increase only 0.8% in the past 12 months. Inflation expectations, as measured by bond yields and Reuters' poll of economists, show the CPI slightly below the midpoint of the government's annual target of 1% to 3%.

Rising home prices remain a problem, with prices up 10.5% in the past year. But the central bank Monday discounted the inflationary impact, noting that new taxes Finance Minster Yair Lapid plans on home transactions are "expected to moderate demand."

If the markets and economists were caught flat-footed by Fischer, one reason was because those twin moves on May 13 have been successful so far. In its minutes on Monday, the central bank noted that between March 24, when the panel had held its last regularly scheduled meeting, and May 12, the shekel had appreciated 2.9% against the dollar.

Since then, the shekel had weakened 3.9% versus the greenback and 3.5% against the euro, the Bank of Israel said.

On Monday the bank didn't set an official exchange rate due to the holidays in Britain and the United States, but the shekel weakened sharply on the rate-cut news and was trading at NIS 3.71 in the early evening. On Friday it had been set at NIS 3.6960.

"Fischer wants to keep the dollar rate at NIS 3.70 at a minimum," said Shmuel Ben Arie, research director for the domestic market at Pioneer Private Wealth Planning. "That is the bottom-line dollar rate the economy needs to grow at least 3% a year . Lower growth would hurt state revenues and deepen the deficit and prevent the economy from recovering in 2014."

Meanwhile, the minutes of the unscheduled May 13 rate cut, which were released May 22, show that the monetary committee had been split between those advocating a reduction of 0.25 point and and those advocating 0.5 point. Fischer, who supported the smaller cut, broke the tie.

Economic growth for now looks to be steady, with gross domestic product expanding at roughly the same 2.8% annual rate as in previous quarters, while exports have rebounded moderately, all of which would mitigate against lowering the interest rate again. But the Bank of Israel on Monday expressed concern that the government's plan to narrow the budget deficit to 3% of GDP in 2014 would crimp demand next year.

With reporting by Reuters.

Tomer Appelbaum