Citi analyst David Lubin says that the Bank of Israel surprise decision yesterday to raise the interest rate by 50 basis points to 3%, from 2.5%, "changes the game".
Lubin says that by apparently abandoning its policy of gradual rate hikes, the bank appears to be admitting failure of its policy to some extent, and leaves analysts less sure of how it will pursue a tightening monetary strategy. Lubin says that the market pricing in 150 basis points of interest rate hikes over the remainder of the year is "probably excessive". He says that a more likely outcome is fewer rate hikes and a stronger shekel.
A jump in inflation expectations over the past two months may be based on strong economic data and a rise in global commodity prices. But Lubin finds a third possible reason - the perception that the Bank of Israel has lost control of inflation. This perception stems from continued negative real interest rates, and from the idea "that the Bank’s commitment to the inflation target has been somehow diluted by its pursuit of exchange rate stability".
Lubin adds that this means a stronger shekel will probably be needed for the bank to push inflation down. "If we are right in thinking that the Bank’s credibility has been affected by its pursuit of an exchange rate target, we think the solution to the Bank’s problem will need to lie in a stronger shekel, not just higher interest rates. Therefore, the Bank will need to stay away from the foreign exchange market, permitting more nominal appreciation, even if that leads to a debate about whether the shekel is becoming overvalued."
Published by Globes [online], Israel business news - www.globes-online.com - on March 29, 2011
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