Inflation forces Fischer's hand

Governor of the Bank of Israel Prof. Stanley Fischer's decision to raise the interest rate by 50 basis points should be examined not because the rate hike is "extraordinary", but also because of what it implies. With this decision, the Bank of Israel is sending a clear signal that, as far as it is concerned, its primary mission is to protect price stability, not the exchange rate.

The practical significance of the decision is that more interest rate hikes will come until the rate is higher than inflation expectations. Export profit margins and mortgage payers' peace of mind are all subordinate objectives, if that, compared with what the central bank perceives as its primary mission.

What has caused this turnaround now? Mostly it is the confluence of two considerations. The first is that the Bank of Israel has to pick up the pace of interest rate hikes, and the second is that it can do so.

The Bank of Israel had to act as it did because of rising inflation expectations. The real interest rate is currently negative, even at 3%, and the Bank of Israel wants, when all is said and done, a positive real interest rate.

It can be assumed that the Bank of Israel is also looking at fiscal policy developments, and sees a government that is losing its discipline to restrain government spending and cannot cope with salary demands. Government spending has become increasing expansive in recent months, eroding the anchors of price stability which the current government inherited from its predecessor.

In explaining the decision, the Bank of Israel cited the rapid rise in home prices in the past year. And while it is important to understand that the Bank of Israel will continue to raise the interest rate even if home prices stop climbing, if the inflation rate does not fall to within the government's target range. The official range is 1-3%; in practice, the Bank of Israel sees a 1.5-2.5% range.

On the other hand, the Bank of Israel feels that it must rapidly raise the interest rate because of the economic expansion. In practice, there is no difference between actual and potential GDP growth. When the Bank of Israel looks at exports, it sees further growth, despite the shekel's appreciation in recent months. Moreover, updated figures indicate that the US is recovering, which helps Israeli exports.

In the immediate term, the shekel will presumably appreciate, which will force the Bank of Israel to intervene to prevent extreme volatility. However, exchange rate analysts should also see what is happening around the world. Israel is not the only country where the interest rate is rising, and economic recovery will presumably lead to interest rate hikes in Europe, and especially the US, albeit not in the next few months.

Furthermore, it is not possible to disassociate foreign exchange forecasts from possible geopolitical developments. For example, it is currently impossible to predict how foreign investors will behave in late summer ahead of UN recognition of a Palestinian state.

All this explains why the Bank of Israel decided to do what it did, and the same calculations will guide it in the coming months. Attention should also be paid to the Bank of Israel Research Department's assessment that an interest rate of 4% is needed to restore inflation to desirable limits. This means more interest rate hikes in the months ahead up to a total of one percentage point. The Bank of Israel is not obligated by this calculation: so long as inflation and inflation expectations do not fall to the desired rate, the interest rate will climb, even beyond one percentage point.

This is almost the only certainty that should be taken into account now, because it is the certainty that the Bank of Israel operates by. There is no commitment about the pace of interest rate hikes; it could be 25 basis points, or 50 basis points, or some other amount. As I emphasized, we are living by new rules and you had better get used to them.

Published by Globes [online], Israel business news - www.globes-online.com - on March 29, 2011