Bank of Israel raises key rate on inflation worries

Faced with an economy starting to emerge from recession and stubborn prices pressures, Israel's central bank on Monday raised short-term borrowing costs by a quarter-point to 0.75 percent on Monday to rein in inflation.

In doing so, the Bank of Israel became the first major central bank to raise interest rates since the global financial crisis prompted a cycle of sharp monetary easing across the world starting nearly a year ago.

Some analysts, noting that Bank of Israel Governor Stanley Fischer had a very tough decision to make, questioned the move as being too quick, since the economy remains weak and inflation pressures tend to ease late in the year.

You need to see real improvements in the world before doing this, said David Karsboel, head of strategy at Saxobank.

While the world's biggest central banks are expected to keep policy steady well into next year, the markets believe smaller central banks could follow Israel in coming months. Many analysts believe Australia may hike rates toward the end of 2009, and that Norway could do so around the end of the year.

The Bank of Israel said the aim of the rate hike was to help inflation get back to its 1-3 percent target.

The decision strikes a balance between the need to moderate inflation and the need to continue to support the recent recovery in economic activity, given that unemployment is expected to continue increasing in the next few months, the central bank said in a statement.

Setting the interest rate at the low level of 0.75 percent continues to represent an expansionary monetary policy.

The rate increase, which was a mild surprise since most economists believed the central bank would wait at least another month, was the first since July 2008 and came after the Bank of Israel cut its key rate by 3.75 points from October to March.

Nine of 12 economists polled by Reuters had predicted no rate move at this time, although eight believed the Bank of Israel would start raising rates by year-end due to concerns over inflation and signs the economy was starting to recover.

FOLLOWS END TO EASING STEPS

In the run-up to the rate increase the Bank of Israel over the last month unwound its radical easing steps, such as buying government bonds and a more than one-year programme of buying $100 million a day in foreign currency that was aimed at weakening the shekel to enable Israeli exports -- nearly half of Israeli economic activity -- to remain competitive.

It said, however, it would intervene on days it deemed there are unusual movements.

The central bank said its move would help return inflation back to target from an annual rate of 3.5 percent in July. It noted that although prices of late have risen on government-imposed tax hikes, inflation was still near the upper end of the target excluding tax factors.

Interest rates had to be hiked because we have inflation, partly because of government spending, and this is a sign from the governor to the market that he will not tolerate high inflation which created a bubble, especially in the real estate market, said Shlomo Maoz, chief economist at the Excellence Nessuah brokerage in Tel Aviv.

The central bank also said most recent data have pointed to an economic turnaround, but there was great uncertainty regarding the expected rate of growth and it remains worried unemployment will rise further.

Israel's economy grew a surprising annualised 1 percent in the second quarter after contracting the final three months of 2008 and the first quarter of 2009. Most analysts forecast zero growth for all of 2009, compared to expectations of a contraction of as much as 1.5 percent.

To prevent a spike in the shekel versus the dollar, the Bank of Israel bought as much as $100 million of foreign currency ahead of the announcement and up to $70 million afterwards, according to dealers. It bought some $2.5 billion this month.

The shekel -- which has appreciated more than 10 percent since late April -- gained marginally to 3.80 per dollar after the rate hike from its official rate of 3.8040.

The Bank of Israel cannot target the currency, and monetary policy has to look at price stability and maintaining the inflation target over a certain amount of years, said HSBC economist Jonathan Katz, one of the few who foresaw a hike. Although he (Fischer) looks at the currency he certainly can't be hostage to a real exchange rate.

The Bank of Israel said it did not expect other leading central banks to start raising rates until the end of the year, or in 2010 but unlike in Israel, inflation in those countries is expected to remain low both this year and next.

Analysts agreed the move was unlikely to signal a large-scale move to tighter policy around the world.

I don't think Israel itself has any...massive consequences. But somebody has raised rates, and that's interesting, said Nick Field of Schroders.

I wouldn't personally expect that we are going to get a massive rush of interest rate rises around the world. I think we are more dribbling toward the end of rate cutting rather than to rate rising.