BOI FOLLOWS FED AND RAISES INTEREST RATE TO

UNCLAS SECTION 01 OF 02 TEL AVIV 005892

SIPDIS

SENSITIVE

E.O. 12958: N/A
TAGS: ECON EFIN IS ECONOMY AND FINANCE
SUBJECT: BOI FOLLOWS FED AND RAISES INTEREST RATE TO
3.75 PERCENT

This cable is Sensitive but Unclassified. Please
handle accordingly.

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Summary
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1. (U) On September 25, the Bank of Israel (BOI)
announced a .25 percent increase in interest rates,
bringing the short-term rate to 3.75 percent. This
was the first change since the Central Bank lowered
rates by 0.2 percent to 3.5 percent at the end of
January, 2005. In its September 25 press release, the
Bank noted that the decision to raise rates was made
in order to maintain price stability, which it defined
as an inflation rate of between one and three percent.
Stanley Fischer, the Central Bank Governor, is known
to prefer an inflation rate of about 2 percent, the
midpoint of the target. In addition to watching
inflation, the Bank of Israel will continue to take
the interest rate decisions of the FED into account in
determining its monetary policy. End Summary.

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Fischer's First Rate Change
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2. (U) The increase was the first action on interest
rates by Fischer since he joined the BOI in May, 2005.
Following the FED's decision on September 20 to raise
rates, there had been speculation as to whether the
BOI would follow suit. The Governor said in an
interview in the September 23 Yediot Aharonot that,
"there is no doubt that an increase in rates in the
U.S. would influence Israel and that the Central Bank
would have to raise rates." He added that the factors
which contribute to inflation would also lead to an
increase in rates.

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Increase Foreshadowed at the End Of August
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3. (U) In its August 29 statement announcing that
interest rates would remain unchanged at 3.5 percent,
the BOI noted increased inflationary pressures
evidenced by the higher than expected 1.1 percent rise
in the July CPI. The statement said that the Bank
would not hesitate to raise rates if warranted by
increased inflation. Although the CPI in August was
only 0.2 percent, inflation forecasts for the next
year have risen as high as 2.4 percent, higher than
the 2 percent BOI goal.

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Factors Behind the Hike
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4. (U) The BOI cited the following reasons for raising
the interest rate:

- Devaluation of the shekel against the dollar; the
shekel declined by 1.2 percent in the last month.

- Recent increases in global oil prices; this was
cited as contributing to pricing pressures in Israel.
Fischer said in a September 23 Haaretz interview that
increases in oil prices in the 1970s and 1980s had a
one-time influence on prices, but the present
situation is much more complex, resulting in a
continuous process of increased oil and raw material
prices.

- The "relatively low level of short-term real
interest rates against the background of relatively
rapid economic growth intrinsically exerts a certain
pressure on prices." Over the last few years when
inflation was very low, and fell below the 2percent
target, some economists claimed that this was an
indication of a low level of economic activity, and
therefore nothing to celebrate. In the present era of
accelerated growth, prices will likely rise.

- Persistent political and economic uncertainty; The
interest rate announcement was made before knowing the
outcome of the Likud Central Committee vote on moving
the party primary forward. However, the unclear time
frame for the planned national political elections in
2006, and the continuing problematic security
situation have resulted in political uncertainty,
which impacts on the financial markets and affects
inflation. It also affects perceptions regarding
economic stability, calling into question the
government's ability to maintain its reform program
and its policy of fiscal restraint, particularly as
the Budget approval season approaches.

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U.S.-Israel Interest Rate Differentials
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5. (U) The Fed action on September 20 raising interest
rates to 3.75 percent created an historical anomaly in
which the short-term interest rate in Israel was lower
than in the United States by .25 percent. However,
Israel's long-term rates continue to be about 1.8
percent higher. As Fischer noted in a September 23
Haaretz interview, this interest rate differential
encourages Israelis to invest in the shekel and keeps
them from sending their money abroad. He added that
conventional thinking used to require about a 2
percent differential between U.S. and Israeli long-
term rates (Comment: to prevent capital flight out of
Israel; end comment),but "we saw that when confidence
in macroeconomic policies increases, it is possible to
reduce the gap to zero."

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Reactions Good, but Hope it's Not a Trend
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6. (U) The reaction of Ohad Marani, Former DG of the
Finance Ministry, and currently Chairman of the
Economic Committee of the Manufacturers Association,
typified the general praise within Israel's economic
sector of the decision to modestly raise rates. He
told Haaretz on September 27 that he hopes the
decision does not presage further increases that could
eventually curb growth and employment.


7. (U) Jonathan Katz, Chief Economist of Leader and
Co., interviewed by The Marker on September 27, said
on the other hand, that the rate increase was puzzling
and the accompanying BOI statement worrisome. He
noted that the BOI in the past had neither an interest
rate differential target nor an exchange rate target.
He said that the prevailing perception that the BOI
was setting such targets should worry the Israeli
capital markets. He explained that interest rate
hikes in the U.S. to as much as 4.5 percent in 2006
could lead to a similar trend in Israel. Given
continued high unemployment (9 percent) and the
ongoing process of recovery, Katz does not want to see
an acceleration in interest rate hikes.

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Comment
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8. (SBU) The rate hike was likely a preemptive strike
against the inflationary pressures that are starting
to build up in the Israeli economy, driven primarily
by increased energy prices. This week, standard grade
gasoline prices in Israel have reached the 6 shekel
per liter level for the first time ever. In addition,
the Central Bureau of Statistics just released its
prediction that the economy's overall growth rate for
2005 will be 5.1 percent, which could further spark
inflation fears in a country where the hyperinflation
of the 1980s is still remembered by many.


9. (SBU) The degree to which the BOI is seen to be
tying its monetary policy to that of the FED might
raise a concern among many in the economic sector that
further hikes in tandem with the FED could stifle
Israel's recovery. However, the BOI had good reason
now to raise rates modestly in order to head off
inflation pressures, regardless of the FED's action.
It will likely act independently in the future as well
to stave off inflation while continuing to nurture
economic growth.
Jones