The Bank of Israel should refrain from further interest rate cuts and be prepared to raise rates if economic growth exceeds forecasts or pressure on the shekel eases, the International Monetary Fund said Monday.
In an annual report that was largely an endorsement of the central bank’s policies, the IMF warned that low interest rates would fuel further house price increases. “The Bank of Israel should be prepared to respond nimbly to changes in the economic environment,” it said.
The report comes as the central bank seeks to juggle a host of policy challenges that require contradictory solutions.
On the one hand, the shekel has appreciated close to 9% against the dollar in the past year, undermining the price competitiveness of Israel’s exports and threatening to slow economic growth. Cutting interest rates would reduce demand for the shekel.
On the other hand, low interest rates have encouraged Israelis to take out mortgages, helping to fuel a surge on housing prices.
Israel’s base lending rate has been falling since 2011 and now stands at just 1%.
The IMF advised using tools other than the interest rates.
To stem the strengthening shekel, it said exchange rate policy should be employed, as the Bank of Israel has been doing by intervening in the foreign currency market. To contain housing prices, it called for further measures like the bank has implemented to restrict access to home loans.
“Most importantly, however, concerted efforts should be made toward alleviating supply-side constraints,” the IMF said.
It was more critical of fiscal policy, gong so far as to propose that an independent fiscal council be formed “as a disciplining and monitoring mechanism.” In particular, the IMF warned that Israel will face a budget squeeze in 2015 and after.
While the IMF said it favored spending reductions, it also warned against relying solely on cuts to put the budget in order.
“Given the low levels of non-interest civilian expenditures in Israel, relying solely on reducing expenditure growth… will compromise long-term growth and sustainability. Therefore additional revenues will be needed,” the report said.
Like the Organization for Economic Cooperation and Development, which issued a report on Israel last week, the IMF said Israel should avoid raising taxes but crack down on evasion and impose new or higher taxes in areas such as the environment.
The IMF forecast Israel’s 2013 economic growth to remain flat at 3.5%, slowing to 3.25% in 2014. A full percentage point of 2013 growth will be due to the onset of natural gas production at the Tamar field.
“Risks to the economic outlook are tilted to the downside,” the report said, citing factors including the risk of prolonged sluggish growth in the United States and Europe.