The European crisis of confidence played into the hands of the Bank of Israel, as fears of a slowdown in exports allegedly justified cutting the interest rate to just 2.5% - a negative interest rate in real terms. Governor of the Bank of Israel Prof. Stanley Fischer's clear interest in preventing the collapse of housing prices sought by many, and blocking the strengthening of the shekel, caused the clay feet of the members of the monetary council to hit the economic accelerator in a way that does not fit the positive macroeconomic conditions.
The picture has since changed. The intervention by the European Central Bank and the fiscal treaty for Eurozone countries has caused yields of government bonds to plummet, and calmed global stock markets.
The Tel Aviv Stock Exchange (TASE) did not cheer the stabilization in Europe and the encouraging figures from the US labor and real estate markets, but investors in government bonds definitely changed their taste in line with the global rebound. Inflation expectations derived from bond pricing have jumped sharply in recent months, moving from a near deflationary environment when the European crisis broke out to the upper end of the government's price stability target.
The improvement in business activity, the rise in the price of oil, and a renewed increase in rents has caused investors to price the difference between CPI-linked government bonds (real yield) and unlinked bonds (nominal yield) at a level that reflects a substantial deviation of 3.5% in the short term, and touches on the inflation target's upper limit for the next ten years.
Such an extreme pricing indicates a complete loss of confidence in Fischer's monetary policy, and raises grave doubts about the analysts' consensus of 2.6% inflation over the next 12 months and another interest rate cut this year.
Subsection 3 (a) (1) of the Bank of Israel Law (5770-2010) states that the objectives of the Bank are "to maintain price stability as its central goal" and Subsection 3 (b) states, "The Government, in consultation with the Governor, shall determine the price-stability range for the purposes of Subsection (a) (1)."
Since 2003, this price stability range has been 1-3% for the year and for each month compared with the corresponding month of the previous year.
The tool available to the Bank of Israel is the interest rate, and law gives the Bank of Israel absolute independence to set the interest rate to meet the inflation target. By law, the Bank of Israel must meet the government's inflation target, even at the expense of other interests, such as protecting exporters and stability of the real estate market.
Now, with the sharp rise in capital market inflation expectations, Fischer cannot ignore the expected overshooting of the price stability target, and he will have to act to maintain price stability, as mandated by the law.
An unexpected interest rate hike (in contrast to expectations of a continuing downward trend in the interest rate) will shake the ground under the fragile feet of takers of prime rate mortgages, and will create a hole in the bursting bubble in the residential real estate market.
Eldar Ganzel is CEO of Astrateg Investment House Ltd.
Published by Globes [online], Israel business news - www.globes-online.com - on February 29, 2012
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