Bank chief: In almost every scenario, damage is substantial

Bank of Israel hikes rate to 4.5%, warns judicial shakeup could badly harm economy

Central bank lifts rates by 0.25%, smallest rise since April; in its pessimistic scenario, potential impact of overhaul could be $14-billion annual hit to GDP over next 3 years

Sharon Wrobel is a tech reporter for The Times of Israel.

Bank of Israel Governor Amir Yaron attends a cabinet meeting at the Prime Minister's Office in Jerusalem, on February 23, 2023. (RONEN ZVULUN / POOL / AFP)
Bank of Israel Governor Amir Yaron attends a cabinet meeting at the Prime Minister's Office in Jerusalem, on February 23, 2023. (RONEN ZVULUN / POOL / AFP)

The Bank of Israel on Monday lifted the benchmark interest rate for the ninth straight meeting, raising its key lending rate by 25 basis points to 4.5 percent, the highest level since before the 2008 crash, as the central bank battles inflation pressure and as “tremendous” uncertainty over the government’s judicial overhaul plan weighs on the economy.

“The uncertainty and the events we witnessed in recent weeks have naturally also had an impact on the Israeli economy,” said Bank of Israel governor Amir Yaron, speaking at a press conference in Jerusalem following the interest rate decision.

Specifically, Yaron warned about the “uncertainty deriving from the legislative processes related to the judicial system” and the substantial impact these could have on the “economic and financial developments in the short term and in the longer term, and therefore on the monetary policy that will be required.”

As negotiations between the government and opposition aimed at compromising on the coalition’s contentious judicial overhaul legislation resumed on Monday at President Isaac Herzog’s office, Yaron raised hopes “that to the extent a decision will be reached that reflects a broad agreement through dialogue and collaboration, the economy will also be better off for it.”

The central bank’s monetary committee decided to raise the benchmark rate to 4.5% from 4.25%, the smallest increase since April 2022. The move comes after inflation quickened at a faster pace than forecast in February and as uncertainty over the repercussions of the proposed changes to the legal system led to a dampening of investor sentiment and a slowdown in investments. Also, at the end of March, the US Federal Reserve raised interest rates by a quarter of a percentage point, amid the global financial turmoil following the recent collapse of two US banks.

The Bank of Israel has steadily raised its benchmark interest rate from a record low of 0.1% last April in a bid to rein in inflation, which has been hovering above 5% in annual terms for the past six months, falling short of the government’s target range of 1% to 3%.

View of Bank of Israel main offices in Jerusalem, on January 2, 2023. Photo by Yonatan Sindel/Flash90

“Economic activity in Israel is at a high level, and is accompanied by a tight labor market, although there is some moderation in a number of indicators,” the central bank said in a statement. “There has been some moderation in annual inflation, but the moderation is slower than previous assessments.”

In what appeared to be an attempt to criticize the Bank of Israel for raising interest rates instead of pausing to see how the hikes affect inflation, Communications Minister Shlomo Karhi called to replace the Bank of Israel chief with a robot.

“Thanks to the governor of the Bank of Israel for the magnificent holiday gift he gave to the citizens of Israel,” Karhi tweeted following the rate decision. “With such opaqueness, on the eve of Passover, perhaps it is possible to put a robot in the position of governor, who will make decisions on interest rate increases based on an objective algorithm, disconnected from the people.”

Alongside the interest rate decision announcement, the Bank of Israel’s research team on Monday also revised its forecast of economic indicators and, in light of the “tremendous” uncertainty due to the proposed changes to the judicial system and their economic implications, prepared two potential scenarios for the economy.

“The transition to two scenarios is a novelty in Bank of Israel publications, and is an exceptional step relative to the past, in view of the complexity of the situation and the degree of uncertainty that has increased markedly,” Bank Leumi chief economist Gil Bufman wrote in a research note following the rate decision.

In the first scenario, which assumes that coalition and opposition reach a broad consensus on the judicial overhaul and resolve disagreements in a way that does not affect economic activity going forward, the economy is predicted to grow by 2.5% in 2023, revised down from the 2.8% forecasted in January, and 3.5% in 2024.

Workers from tech sector protest against the government’s planned judicial overhaul, in Tel Aviv, on March 9, 2023 (Tomer Neuberg/Flash90)

The unemployment rate is expected to average 4.1% in 2023 and 4% in 2024. Central bank economists see the inflation rate easing to 3.9% by the end of this year, versus 3% forecasted in January, and moving to 2.3% in 2024.

In the second scenario, central bank economists presented an analysis of the potential economic ramifications depending on the intensity of the shocks over the next three years if the proposed legislative and institutional changes lead to an increase in Israel’s risk premium, have a negative impact on exports, push domestic investment down and dampen demand for private consumption.

In a case where the shock of the legislative changes subsides relatively quickly, the potential impact could be a 0.8% annual hit to GDP over the next three years. In case shocks from the changes persist, the adverse impact is estimated at about 2.8% to GDP per year over the coming three years.

“These scenarios do not include reference to the different paths expected for inflation, the exchange rate and the interest rate,” commented Bufman.

Hebrew media calculated the impact of the bank’s more optimistic scenario at NIS 14 billion ($3.9 billion), and its more pessimistic scenario at NIS 50 billion ($13.9 billion) per year for the next three years.

Yaron confirmed these figures in television interviews on Monday night, telling the Kan state broadcaster that if the legislation goes through but the crisis is “temporary,” the annual cost would be some NIS 14 billion, but “if it is perceived that [the instability produced by the overhaul] will be protracted, then [the cost] would be almost NIS 50 billion per year over three years.”

Asked about the forecasts of potential annual costs in the tens of billions of shekels, Yaron told Channel 12 on Monday evening: “The decision-makers must pay attention: In almost every scenario, the damage is substantial. The longer [the overhaul process] is perceived to be likely to take and to continue, the more the damage is likely to be very substantial.”

Tech workers protest against the government’s judicial overhaul ‘time is running out for Israeli hi-tech,’ in Tel Aviv, on March 23, 2023 (Avshalom Sassoni/Flash90)

He noted comments from people in high-tech and other elements of the economy to the effect that investors “are on the fence.”

“If a solution is found, with wide agreement and via cooperation… the potential damage… will be overcome more quickly,” he said. “Uncertainty is a bad thing in the economy, certainly as regards all the things that are taking place now,” he added.

On Saturday night, hundreds of thousands of people demonstrated throughout the country against the government’s judicial overhaul plans even as Prime Minister Benjamin Netanyahu’s hard-right coalition last week paused the legislation on the proposed changes to allow dialogue on its highly divisive efforts to weaken the justice system.

“Political uncertainty will probably continue to be a significant factor in the coming months, affecting the mood of investors from abroad and consumers in Israel,” according to economists at Bank Hapoalim.

Among the demonstrators are many leading entrepreneurs, investors and tech workers, who have in recent months voiced their opposition to the proposed changes which would grant the government more weight in the selection of judges while curbing the Supreme Court’s power to strike down legislation.

The main concern is that the judicial overhaul will erode democracy and weaken checks and balances, which in turn is feared will make venture capitalists and other money makers leery of investing their money in the country, triggering an outflow of funds.

Israeli tech unicorn Riskified is the latest local firm to announce that it would be transferring $500 million out of the country and offering a limited number of relocation packages to interested staff members.

The Bank of Israel noted that there are already developments in the markets indicating an increase in the economy’s risk premium.

“While prices increased on capital markets worldwide for the year to date, equity indices in Israel have underperformed them and have declined over the year to date,” said Yaron. “There was high volatility in the shekel in recent weeks — which was also impacted by the recent events in the country.”

“From the beginning of the year, there has been a marked depreciation of the shekel vis-à-vis the dollar and in terms of the nominal effective exchange rate, and even some separation from the strong connection that there was between the S&P 500 and the exchange rate,” he added.

In recent weeks, Yaron has cautioned against the potential economic danger posed by the government’s push to curb the justice system, warning about a slowdown to investments into the local tech industry and risks of a brain drain.

Israeli tech companies raised $1.7 billion in the first quarter of this year, down 70% from the $5.8 billion in the first three months of 2022, according to a report by IVC Research Center and LeumiTech released on Sunday. The quarter marked the lowest figure in four years. The tech sector employs about 10% of the country’s workforce accounting for around 15% of GDP, more than half of exports and about 25% of tax income.

Yaron indicated that the central bank’s interest rate hiking cycle could soon be coming to an end, while not ruling out further rate increases should inflation surprise and not moderate at the forecasted pace.

“Looking ahead, the Bank of Israel is expected to continue raising the interest rate probably by 25 basis points in the upcoming decision,” said Bufman. “To the extent that the pessimistic scenario materializes, it appears that this will be reflected in a sharper increase in inflation and in the interest rate than in a scenario in which there is moderation in the scope of risks.”

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