The Bank of Israel (BOI) surprised the markets on November 26th by raising its cash rate for the first time in over seven years. The BOI raised rates by 0.15 percentage point – to 0.25%. This “lift-off” — although at this point it’s more of a modest pickup – seems a bit odd considering the BOI still doesn’t have its new Governor, Amir Yaron, who is expected to enter office on December 24. Moreover, inflation hasn’t risen to a level that warrants such a reaction. Since the market was expecting the Bank to raise rates sometime early next year such a rate hike could have easily been postponed.
All these circumstances raise the question of why now the Bank decided to hike interest rates?
The reasons are likely related to wages and Israel’s trade balance. As for the timing of the hike, I think it has to do with changing market expectations by a surprise move. Let’s explore the issues in further detail.
Israel’s inflation has picked up in recent months. Moreover, while it is still nowhere near an alarming level — it has finally reached the Bank’s inflation target range of 1% to 3% back in June – the current level allows the Bank to justify raising interest rates, even a tiny bit, as inflation is finally within its target. Furthermore, wages are likely to be a more significant concern for the BOI even though higher wages are, in general, good for consumers and by extension, the economy. Persistently high growth in wages without a fall in unemployment or a rise in GDP growth could be a sign of possible higher inflation down the line.
Since wages are “sticky” and in downturns tend to remain high – no one likes a wage cut – the economy could wind up with higher inflation and little growth. This doesn’t mean the Israeli economy is in trouble; it is still doing well: Unemployment is around 4%, and jobs vacancies are at all time low. However, wages continue to rise, and unemployment remains anchored to the 4% level. And we have also seen some evidence for slower GDP growth in recent quarters. These findings could suggest (as explained by a simple Phillips curve) that perhaps Israel’s U* is around 4% and from this point on wages will keep rising but the country won’t benefit from higher economic growth or lower unemployment.
Then there is Israel’s current account: While it’s still in positive territory, it has also been coming down in recent quarters. This trend is mainly due to sluggish growth in exports and a sharp rise in imports (a rising trade deficit) – probably also has to do with a wealth effect due to higher wages. The decline in the current account has occurred as the New Israeli Shekel depreciated both against the USD and the Euro in the last six months. So even the weaker NIS didn’t curb down the growth in Israeli imports nor did it help boost exports. These trends are another indicator for slower economic growth.
The BOI did point out to slower growth in GDP, and concerns over a stronger NIS – although raising interest rates aren’t likely to help. However, on wages they only mentioned the following:
“The rise in wages in the economy and the expansionary fiscal policy will support the continued entrenchment of inflation within the target.”
They didn’t refer to wage growth as a cause for concern. Perhaps no one in the BOI wants to ring the alarm on higher wages. However, they did acknowledge that higher wages are among the culprits to further push inflation higher.
So, what’s behind the BOI’s decision?
As I see it, the BOI’s recent maneuver is mostly “academic” in the sense that it resembles more of a classroom exercise than something that is expected to do much in reality.
The BOI decided to surprise the markets – hence the weird timing, between Governors – by raising rates by a minimal margin. It aimed to draw enough attention towards this policy change without causing any disruptions to the financial markets or weigh too heavily on the economy — especially considering its recent slowdown. Because of its timing and surprise to the markets, this hike should have also revised expectations; it should have also signaled to corporations that interest rates might rise again. Therefore, the BOI’s message was that companies should curb down their wage hikes and not create further inflationary pressures with little added boost to productivity. In short, the BOI wanted to draw attention to its policy shift with the smallest adverse impact on the economy.
Will this “shot across the bow” rate hike work?
So far, the reaction in the financial markets was, as expected, a surprise. The USD/NIS exchange rate did fall by over 0.7% on the day of the announcement before climbing back to where it was before the BOI’s announcement. It’s hard to see how such a small rate hike could be enough even to change a bit market expectation and adjust people and companies’ behaviors in such a low interest rate environment. Moreover, slower economic growth is only likely to keep the BOI from raising rate much further especially since inflation is still close to the lower bound of its target. Given the current circumstances, and considering we don’t know how will the new Governor lead the bank’s policy, the BOI’s move might seem prudent albeit it will likely to do very little in revising expectations (just ask Bernanke or Draghi as to how hard it is to change market expectations).