The obvious explanation is that Stanley Fischer, the governor of the Bank of Israel, raised interest rates for March by 0.5 points to 3% on Monday, and the shekel has strengthened.
The dollar extended its fall against the shekel yesterday, losing another 0.9% against the local currency. The representative rate dropped to NIS 3.481 − the lowest representative rate in more than two and a half years. The greenback fell even lower in after-hours trading to NIS 4.77. The obvious explanation is that Stanley Fischer, the governor of the Bank of Israel, raised interest rates for March by 0.5 points to 3% on Monday, and the shekel has strengthened as the gap between U.S. and Israeli rates has widened to a full 3%. In July 2008 the dollar hit a low of NIS 3.23.
The Bank of Israel also intervened in trading after the representative rate was set; it bought $250 million. The central bank bought $24 billion in foreign currency in 2009 to steady the forex markets and another $12 billion in 2010 to continue propping up the dollar.
The euro rose yesterday against the dollar on expectations that the European Central Bank will raise interest rates in April despite the euro-zone debt crisis. Locally, the euro rose very slightly against the shekel to a representative rate of NIS 4.949.
As to what Fischer thinks, on Wednesday the central bank released its 2010 annual report. “The Bank of Israel will be prepared to intervene in the foreign exchange market if the exchange rate deviates from its equilibrium level,” it said. “The bank will also take the necessary steps to maintain financial stability, and in this context it is important to prevent the formation of a bubble in housing prices.”
According to Kubilay Ozturk, an economist at Deutsche Bank, “The preemptive move to hike rates more than expected will be conducive for restoring the Bank of Israel’s credibility. This will also send a good signal to the markets that inflationary expectations will not remain unanchored.”
Before the latest rate increase, the Bank of Israel had already boosted its key rate eight times since August 2009 from a low of 0.5%. But as consumer prices started to rise rapidly in the past few months, repeatedly topping analysts’ monthly forecasts, many investors believed policymakers were losing the battle with inflation.
Despite the rate hikes, the benchmark 10-year government bond yield rose 30 basis points over the past month, peaking at 5.35% on Monday just before the latest rate move. In all, the yield − a barometer for the inflation outlook − jumped some 70 bps since the beginning of the year.
That trend was at least temporarily reversed on Tuesday, when the 10-year yield slipped to 5.33%, while short-term yields rose to reflect expectations for more rate hikes this year.
Most analysts and the Bank of Israel’s own model now forecast the key rate rising another percentage point to 4% by the end of the year.
Gil Chen, head bond trader at the IBI brokerage, said there had been heavy selling of inflation-linked bonds in favor of fixed-rate bonds after the Bank of Israel’s action.
HSBC economist Jonathan Katz noted that before the latest hike, the market was expecting inflation to exceed the government’s target of 1% to 3% for the next five years. It is not yet clear how much those expectations are changing; the central bank will next release monthly data on inflation expectations in late April.
But Katz said, “People were basically saying that he will consistently miss the inflation target, so he was losing a bit of credibility. I think he has regained that in part.”
Inflation, boosted by housing, energy and food costs, reached an annual rate of 4.2% in February and is expected by analysts to stay at around 4% for the rest of 2011.
Fischer had been reluctant to move interest rates more than a quarter-point at a time to prevent a rapid appreciation of the shekel, which would damage exports − more than 40% of Israel’s economic activity. The shekel has moved little since the latest rate hike, largely because of expectations that the central bank could intervene in the market if necessary, or the authorities could conceivably impose stricter capital controls.
Analysts are unsure whether Monday’s half-point increase in Israel was a one-off event or the start of a trend for the central bank. But Barclays economist Daniel Hewitt, the lone analyst who had predicted a half-point move this week, expects a similar move next month. “Its gradual rate increases have not been enough to keep inflation under control,” he said.
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