Bank of Israel catches economists off guard in first rate hike since 2011

The decision of the Bank of Israel on Monday to raise its key lending rate for the first time since 2011, caught investors, economists, and the capital markets by surprise, with analysts saying the timing is not right, especially since the decision was made by the central bank’s monetary committee just before a new governor takes his post.

“What was the rush,” asked Yaniv Pagot, an economist and head of strategy at the Ayalon Group, an institutional investor, by phone with The Times of Israel. “It feels like a little bit like when the cat’s away the mice will play. There was no governor in charge, so they said, let’s steal the process.”

Citing higher inflation and strong economic growth, with full employment, the central bank on Monday raised its key lending rate by 0.15 percentage points to 0.25%, after leaving it unchanged at a record low of 0.1% since 2015. The new rate will come into effect on Thursday.

The decision was taken by the bank’s monetary committee, led by the deputy governor Nadine Baudot-Trajtenberg, who is currently acting as the chief of the central bank. The new Bank of Israel governor, Amir Yaron, will take up his post on December 24.

Bank of Israel deputy governor Nadine Baudot-Trajtenberg (YouTube screenshot)

“We came to the conclusion that the conditions are ripe for a rise of the rates,” deputy governor Nadine Baudot-Trajtenberg said in a Hebrew YouTube video posted by the Bank of Israel. “This is a small rise,” she said, but a “significant one” as it comes after almost four years in which the rate was unchanged at 0.1%.

The inflation rate has already returned to within the target range of 1% to 3%, set by the central bank, she said, and the economy, even if it registered “very moderate growth” in the last two quarters, was still growing at “a handsome pace.”

“After a continued rise in inflation since the beginning of 2018, the inflation rate is stabilizing slightly above the lower bound of the target range, and is expected to remain within the target in the coming months as well,” the central bank said in a statement, explaining its decision.

Annual inflation was 1.2% in October, and “one-year expectations and forecasts from the various sources hover around the level of one percent,” the central bank said in its statement.

Medium-term expectations remained entrenched within the target range, the statement said. “The rise in wages in the economy and the expansionary fiscal policy will support the continued entrenchment of inflation within the target. The main risk to this is the possibility of a sharp appreciation of the shekel.”

The statement added that, even if in the second and third quarters there was some slowdown in the economy’s growth rate, “current indicators of activity support the assessment that the economy is at full employment, and in particular, the tight labor market data indicate a high level of demand.”

Finance professor Amir Yaron. (The Wharton School, University of Pennsylvania)

Baudot-Trajtenberg said the committee was well aware that the decision for the rate rise was taken without a governor at the helm, but said data and economic analysis led to the decision.

“The monetary committee was very aware that we are in a transitional period,” she said in the video. “We also discussed this,” she said. “But as in all our other decisions the monetary committee members thought that decisions must be taken only on the basis data and economic analysis.”

Why a rate hike now?

The Bank of Israel, like other central banks around the world, is charged with maintaining price stability in the economy — thus keeping inflation in check — to help create a business environment that helps economic growth. The central bank also supports the other objectives of the government’s economic policy, especially economic growth, employment, reducing social gaps and supporting the stability of the financial system.

Price stability is defined in terms of an inflation target that the government has been setting since 1992. The objective of the central bank’s monetary policy is to attain the target. To attain the inflation target, the Bank of Israel sets the level of short-term interest rates. Too low a level of interest leads to inflationary pressures — and price rises — while too steep a rise in the rate of interest results in an excessive restraint of economic activity.

Since the financial meltdown on 2008, considered to be the worst since the great depression of the ’30s, central banks globally, including the Bank of Israel, drastically cut rates to help boost the growth of their economies. Lower rates mean that the cost of borrowing money is lower. This enables individuals and companies to borrow more money — at lower costs — and invest in the stock exchange or in homes or in machinery for their businesses. This creates a ripple effect of increased spending, which helps economic growth.

Since the last rate hike in Israel in 2011, the rates dropped to a record low of 0.1% in 2015 and had remained at those levels, until its rise on Monday. Other central banks have also been raising their rates, as economies globally are recovering from the crisis. In the US, the Federal Reserve has been raising its rates since 2015.

Israel’s central bank believes that Israel’s stronger economy and the inflation that is within the target range, justify a rate rise now.

Who will benefit from the rate rise, who will suffer

The main beneficiaries of the interest rate rise will be the Israeli banks and financial institutions who make an income from lending money.

Consumers who have money in savings accounts in the bank will also benefit from the higher interest rates on their funds.

Those who need to borrow money however — both companies or individuals — will now have to pay higher interest on the loans they have taken, and the decision will impact mainly the highly leveraged industries, like construction firms or holding companies.

Yaniv Pagot, an economist and head of strategy for the Ayalon Group. (Courtesy)

“The rise in the rate is not dramatic, but it could be if the trend continues,” Ayalon’s Pagot said by phone. “It makes whoever is leveraged more vulnerable. Companies and consumers have forgotten what it means to pay significant interest on their debt.”

Indeed, the shares of real estate firms and holding companies, which are highly leveraged, fell on Monday, following the rate decision, while those of banks rose. The shekel, which had declined 3.2% against the dollar since the last interest rate decision, was up 0.5% to 3.7120 per dollar after the announcement on Monday, according to data compiled by Reuters.

A trend of higher interest rates also could cause an appreciation of the shekel, and thus can negatively impact Israeli exports, as holding shekels yields greater interest payments than before.

Interest rates will also rise for private individuals who have outstanding loans or have to take new loans and those who have mortgages, as repayments may rise, depending on the kind of loan they have.

The rate rise is minor and is not expected to affect the financials of companies or individuals, Meitav Dash Brokerage said in a note to investors. But that could change if the markets interpret this single move as “a trend.” Then also long-term rates could rise, the brokerage said. Mortgage rates were on their way up already before the central bank’s rate rise.

“Higher mortgage rates will add to a slowdown in the real estate market and weigh on the whole economy, adding fuel to the fire,” said Amir Kahanovich, the chief economist at The Phoenix Insurance Company Ltd. & Excellence Nessuah Investment House Ltd. in a note.

Lack of visibility

Just two of the 12 economists surveyed by Reuters had forecast a rise in the rate, while 10 others had expected the rate to remain unchanged.

What made the decision even more surprising, said Gil Bufman, the chief economist at Bank Leumi Le-Israel Ltd. in an emailed note to investors, was that at the last rate decision, on October 8, the central bank’s economists revised their expectations for a rate rise, saying they now expected a rate increase only in the first quarter of 2019, as opposed to the fourth quarter of 2018, given lower than expected inflation.

Gil Bufman, the chief economist at Bank Leumi Le-Israel Ltd. (Courtesy)

“Since the last decision at the beginning of October, inflation expectations have declined slightly, the price of oil has collapsed by about 30%, and growth data for the third quarter of the year were slightly lower than expected, so that the timing of the interest rate hike seemed somewhat puzzling,” he wrote.

“Somewhat surprisingly, the reasons the bank cited for raising the rate were the same it used in the past for not rising the rate,” namely the fact that inflation is at the bottom of the target range, wrote Ofer Klein, the head of the economics and research department at Harel Insurance & Finance in a note. Even so, he said, he does not see the rate rise as a change in direction.

“The central bank will not hurry” to raise the rate in coming months, due to the slower economic growth posted in the two past quarters, a forecasted decline in global economic growth and a drop in oil prices.” He said that he expects just one or at most two rate rises during 2019.

Ayalon’s Pagot said the central bank expectations management was “unacceptable. There is no visibility regarding monetary policy,” as opposed to Europe and the US, where the central banks prepared the market in advance on their policies, and “no one is surprised.”

This visibility is even more put into question as the new central bank governor takes his post at the helm of the bank next month, he said.

“He is a black box for the market and we don’t know his monetary policies.”