After raising interest rates ten times in a row, the Monetary Committee of the Bank of Israel meets again next Monday to make one of the most interesting decisions of the past year. It is not entirely clear if there will be another hike, which would raise the interest rate above the current 4.75%. Economists have been cutting and changing their expectations for this interest rate decision. A few weeks ago, the market was expecting another rate hike in July of 60%. Immediately after the publication of the Consumer Price Index (CPI) in mid-June, which surprised the good and showed the annual inflation rate in Israel dropping to 4.6%, the probability dropped to almost zero. In recent days, the winds have changed direction again, and quite a few economists once again expect another rate hike.
The vicious circle of shekels and inflation
What has caused forecasts to change over the past few weeks? One of the main factors determining whether the interest rate will be raised is the shekel exchange rate. The Governor of the Bank of Israel, Prof. Amir Yaron, said a few weeks ago that “the exchange rate is perhaps the most important variable these days with regard to inflation.” According to Yaron, “For every percentage decline (at the shekel-dollar exchange rate), prices rise by 0.2%. We have excess inflation of at least 1%.” The Central Bank explicitly says that changes in the exchange rate are mainly due to domestic factors and are “influenced by events surrounding legislative changes.”
Last week, Morgan Stanley released a report on the state of the Israeli economy that attempted to analyze the impact of the crisis and political uncertainty in Israel on the local economy. According to her analysis, “In the opposite scenario, as tensions over judicial reform persist for longer or even escalate, the higher risk premium and shekel depreciation would translate into higher inflation, averaging 5.1% in 2023, forcing further tightening by the Bank.” . from Israel to 6.25%.” In other cases, the interest rate will rise by another 1.5% from its current level of 4.75%. Morgan Stanley believes that the Bank of Israel will raise its interest rate next week by 0.25% to 5% – a level not seen since 2006.
But this may be an oversimplified estimate. Morgan Stanley forecasts were issued after a degree of recovery for the shekel against the dollar. The American investment bank made it clear that due to the decline in inflation in May and a certain recovery in the shekel, it expects a 0.25% appreciation in July, after which the Bank of Israel will be able to measure the impact of interest rates and interest rate tightening. economy so far. But since then the picture in the foreign exchange market has changed dramatically with the shekel losing ground.
On June 16, the exchange rate of the shekel to the dollar was 3.56 shekels/dollar. Since then, the US currency has appreciated by more than 4% against the shekel, crossing the threshold of 3.70 shekels/dollar. The shekel’s weakness over the past few weeks has been attributed mainly to judicial reform, which the coalition plans to unilaterally advance in the Knesset, starting with legislation to curtail judicial review by limiting courts’ ability to overrule Central Committee decisions. And local and public government officials on the basis of excessive unreasonableness.
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But this week an additional factor was introduced against the shekel – the security tensions in Judea and Samaria. After the launch of the IDF’s military operation in Jenin, the value of the shekel fell 0.5% on Monday, amid stormy trading on local foreigners, though the drop abated by the afternoon. If the military operation continues, it could fuel uncertainty in the local market and push the shekel-dollar exchange rate higher.
“Past experience has shown that as long as we are talking about targeted measures, the impact on economic activity is very limited,” said Ronen Menachem, chief economist at Mizrahi Tefahot Bank. However, Menachem stresses that the impact on the foreign exchange market depends on the duration of the operation in Jenin. A variety of scenarios need to be taken into account and it is the action dynamics that will influence the direction and level of trading volatility, as long as it continues.”
IBI chief economist Rafi Gozlan said the Jenin operation is a secondary factor in the shekel’s weakening. He explains that “the market learns from military operations and does not attach much weight to them.” He added, “The judicial issue is the dominant issue that causes the shekel to weaken and increases the possibility of an interest rate hike next week as the decline continues.”
Gozlan estimates that only if the shekel-dollar exchange rate remains above 3.7 shekels/dollar could the Bank of Israel raise the interest rate. “When you look at the evolution of inflation, you see that the element that adjusts for the increase is the tradable products, which are affected by the exchange rate. Thus, as consumption increases, general inflation will be higher, and it will cause interest rates to continue to rise.”
Bank Leumi believes that the central bank “will take a time out and leave the interest rate unchanged in the next decision,” and even expects that “the Bank of Israel may be able to leave the interest rate unchanged until the end of the year.” But they also believe that the exchange rate will also have an impact on interest rates continuing to rise.
Published by Globes, Israel business news – en.globes.co.il – on July 3, 2023.
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