Israelis Will Feel the Impact of America's Dramatic Rate Hike

The Fed’s decision will be felt in the tech sector and weaken the shekel. The Bank of Israel, also grappling with inflation, will make things even more painful

David Rosenberg
David Rosenberg
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Israelis will feel the impact of U.S. Federal Reserve raising the interest rate by 0.75% in various ways
Israelis will feel the impact of U.S. Federal Reserve raising the interest rate by 0.75% in various waysCredit: Alexey Bogoslavsky; Artwork by Anastasia Shub
David Rosenberg
David Rosenberg

To ordinary Israelis, the dramatic increase in interest rates that the U.S. Federal Reserve announced on Wednesday may seem like a classic case of someone else’s problem.

But it isn’t. The American economy is feeling the sharp edge of a rapidly changing global economy – one of rising inflation, higher interest rates and slowing economic growth, possibly even recession in the not-too-distant future. But Israel is undergoing the same changes as well, even if our numbers are less extreme.

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U.S. inflation accelerated to 8.6 percent in May from a year ago, the highest increase since December 1981; in Israel, May inflation was steep as well, but just 4.1 percent. To combat the rising inflation, the U.S. Federal Reserve has boosted its base lending rate 1.5 percent points to 1.75 percent as of Wednesday. The Bank of Israel has, by comparison, made do with a mere 0.65 point to 0.75 percent.

But this is just the beginning of what most economists believe will be a period of higher inflation and rising interest rates over the next year or two. The Bank of Israel, basing its forecast on what economists and the financial markets are predicting, sees inflation standing at 3 percent or more over the next 12 months. It expects its base lending rate to double to 1.5 percent.

These aren’t shockingly high numbers by historical standards, but after more than a decade of zero inflation and zero interest rates, it will take some getting used to.

Unless you are borrowing in dollars, rising U.S. borrowing costs only have an indirect impact on the Israelis – but these can be quite significant.

The shekel has weakened 11 percent against the dollar since the start of this year, and the pace has accelerated as the Fed has hiked rates.

Why is that? Lots of investment money moves around the world in search of the highest rate of interest, and when U.S. rates are rising so much faster than Israeli ones, money moves out of Israel and the shekel loses value.

The depreciation isn’t likely to turn into a rout, because Israel’s economic fundamentals remain strong, but a weaker shekel invariably feeds into higher prices for imported goods and, of course, is coming inconveniently just as many Israelis are getting ready to take their summer holidays in Europe and the U.S.

There is one sector of the economy that is almost certainly going to feel the pinch of higher U.S. rate, and that’s high-tech – and that could reverberate across the entire Israeli economy, since the sector is the engine that drives it.

The global tech industry has enjoyed enormous growth in recent years, not just because the coronavirus pandemic caused surging demand for high technology, but also because low interest rates caused investors to put more and more money into tech stocks and startups where they earned a better return on their money. Last year, Israeli startups raised almost $26 billion, more than five times the figure five years earlier. That enabled new companies to be formed, and older ones to hire and expand. But now that easy money is drying up.

Even if they are more modest, the Bank of Israel’s rate hikes have much wider repercussions for Israelis. Businesses will find borrowing costs higher, increasing their expenses and making it harder to expand and take on new employees. Consumers will also find getting a loan more expensive, since most consumer loans are linked (indirectly) to the Bank of Israel rate.

Israelis holding a mortgage or who are looking to get one are going to take a particularly big hit, since mortgage loans are almost always very large and constitute a major monthly expense. Rates on fixed-interest home loans have already risen 1.5 points since the start of the year. Jonathan Berliner, chairman of Mortgage Advisers Association’s professional committee, told TheMarker recently that repayments for a borrower holding a 1 million shekel ($290,000) mortgage have increased by 500 shekels a month.

There is an upside to this, although it won’t entirely compensate for the pain mortgage borrowers are feeling: Higher borrowing costs are going to deter home buyers from entering the market, thereby easing the demand pressure that has pushed housing prices up more than 15 percent in the past year.

But the impact will probably be very limited. For one, the supply-demand balance remains unfavorable overall and for another, borrowing remains still pretty low on a historical basis. In any case, it seems the Israeli real estate market is haunted by years of failed government promises to rein in price hikes. That skepticism isn’t likely to diminish, raising the bar at which potential buyers drop out of the market in hopes for better conditions tomorrow.

The big question is whether the Bank of Israel and central bank peers can tackle inflation and at what cost to their economies. Somewhat akin to chemotherapy and cancer, the interest rate cure is quite painful, but it’s still a long-shot that’s better than the inflation disease. Inflation eats into incomes, especially for the poor, and distorts economic choices.

The catch is that big rate hikes over an extended period risk putting economies into recession. In Israel, recession talk is still muted, even though gross domestic product contracted by 1.9 percent in the first quarter, according to revised figures released on Thursday. The economy is still feeling post-COVID gyrations that have seen quarterly numbers bounce up and down, but overall growth remains quite strong.

But in the U.S., recession talk is in the air, especially after the Fed opted for such a sharp rate hike on Wednesday. If U.S. and/or the world enters a recession, it will be very difficult for Israel to stand aloof. because our economy is much too globalized.

An even worse scenario is that the world’s central banks fail to get a grip on inflation but tip the economy into recession trying to do so, bringing back 1970s-style stagnation. The world is a long way from there – and Israel even longer – but Israelis face some interesting times ahead.

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