BoI hikes interest rate by 0.50% 0 a 15-year high; is it the right move? - analysis

The Bank of Israel raised the interest rate 0.5% to 4.25% on Monday. It was the latest in a series of increases over the past year in an effort to lower the 5.4% inflation rate, which has been rising for months.

The interest rate is now the highest it has been in about 15 years. Prior to the adjustment, experts were unsure whether the central bank would be more conservative in its raise. In January, it said 4% was its expected interest-rate ceiling.

However, based on recently issued inflation data, some analysts believed a half-percentage-point hike was more likely.

“Given the latest inflation point is the highest in the cycle yet, the market is now pricing in a higher probability of a [0.50%] hike,” Citi strategist Bhumika Gupta said Sunday.

Are these interest rate increases even working?

It remains to be seen whether the interest-rate increases will be effective. Faced with a continuously rising rate of inflation and cost of living, the Bank of Israel has repeatedly increased the interest rate, with limited success. The first increase was last April, when the central bank raised its rate to 0.35% from 0.1%.

At the time, many analysts believed such an increase would yield results, but 10 months and 3.4 percentage points later, the increased interest rate has yet to stop inflation.

According to Prof. Dan Ben-David, head of the Shoresh Institution for Socioeconomic Research and an economist at Tel Aviv University, the Bank of Israel currently faces a strong predicament.

“The primary problem is that the Bank of Israel is trying to feel its way through the dark,” he said, adding that without knowing the root cause of the inflation, it is very difficult to prescribe the proper economic remedy.

Finding the root of the inflation is critical

An interest-rate increase could be either very helpful or very harmful, depending on what the root cause of inflation is, Ben-David said.

If the cause stems from people’s readiness to spend the money the government gave them during the COVID-19 pandemic, “then the primary source of inflation is actually from the demand side, in which case the raising of interest rates cools down demand and, subsequently, inflation,” he said.

On the other hand, “if increased inflation is because inflation rates in the other developed countries are higher and are thus ‘imported’ to Israel from abroad, then the problem is one of higher costs emanating from the supply side,” he added. “Raising interest rates in this case would only exacerbate the inflation problem by raising local production costs even further.”

In a shocking twist: politics have caused problems

The answer is not binary, however, and is a mixture of both, plus a healthy dose of political interference, Ben-David said.

“The new government’s coalition agreements are written as though no one ever heard of the concept of budget constraints,” he said. “These agreements threaten to blow the budget to extreme levels, which in turn require contractionary monetary policy – among other things, higher interest rates – by the Bank of Israel to counter the extremely expansionary fiscal policies advocated by the cabinet ministers.”

The new government and its controversial judicial reforms – which critics such as academics and executives say will harm the economy – have caused a notable downward trend in the nation’s internal investment, Ben-David said.

Data illustrating the gap between Israeli and US stock markets show that following the November 1 election, a rapid increase in Israeli stock prices compared with US stock prices was quickly reversed, he said. This suggests the rapid removal of investment in the Israeli stock market as investors pulled their funds from the economy in anticipation of a crash brought on by the judicial reforms’ destabilization of the nation’s system of checks and balances.

“In this context, stock markets reflect the canary in the coal mine,” Ben-David said. “Investors begin to act immediately according to what they expect to happen in order to profit when what they anticipate actually transpires. Thus, although Israel’s economy has been doing much better than nearly all other developed economies over the past year, the election-time, stock-exchange pivot provides an indication that many people are already acting upon their concerns.”

Balancing act

Politics aside, the question of whether an interest-rate increase will harm or help remains to be answered. The Bank of Israel is in a less-than-ideal position in this regard, as an attempt to solve one inflation cause may exacerbate the impact of the other.

Dubi Amitai, head of the Israeli Presidency of Business Organizations, criticized the Bank of Israel’s repeated use of interest-rate increases as its primary tool for dealing with inflation.

“Another interest-rate increase is a severe blow to the business sector and the economy,” he said. “It is clear that the governor of the Bank of Israel is troubled by the weakening of the shekel. But excessive use of the interest-rate tool exacts a heavy price, not only in the slowdown in consumption but also in the slowdown in investments. This will be reflected in the economy’s recovery time, which will be longer than expected – and only once inflation is completely curbed.”

“The effects of the interest-rate hikes are already being reflected in the economy,” he added. “Therefore, at this point in time, the governor of the Bank of Israel must examine processes of lowering the interest rate instead of continuing to raise it.”

The government “must ensure budgetary restraint” in its upcoming budget proposal this Thursday “in order to prevent another inflationary spiral,” Amitai said.