ISRAEL HIKES INTEREST RATE TO HEAD OFF INFLATION

C O N F I D E N T I A L SECTION 01 OF 03 TEL AVIV 001886

SIPDIS

NEA/IPA FOR GOLDBERGER, FRELICH; EEB/IFD FOR PURDUE,
TREASURY FOR BALIN

E.O. 12958: DECL: 08/27/2019
TAGS: ECON EFIN IS
SUBJECT: ISRAEL HIKES INTEREST RATE TO HEAD OFF INFLATION
AS ECONOMY IMPROVES

Classified By: Economic Counselor David R. Burnett; reasons 1.4 b/d


1. (SBU) Amid intense Israeli and international speculation,
the Bank of ISRAEL (BoI) became the first central bank to
raise interest rates since initial signs of a global
recovery. The August 24 hike of 0.25 percent brings the
BoI's benchmark rate to 0.75 percent, up from 0.50 percent
where it had been since March 2009. BOI Governor Stanley
Fischer moved quickly to fight signs of inflation, signaling
to the market that for the BOI, maintaining price stability
supersedes all other considerations. Though it was widely
anticipated that ISRAEL would raise its interest rate sooner
than most other central banks, Fischer's move increased his
stature as a trailblazer, and the "elder statesman of the
global central banking community," as he was deemed by an
August 24 Financial Times article. Against this backdrop,
recent economic data indicate that after two quarters of
contraction, the Israeli economy has reached a turning point
and is moving toward recovery. End Summary.

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Inflation Trumps Exchange Rate Levels
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2. (U) The Bank's decision to increase interest rates
stemmed mainly from the desire to curb inflation to the
target 1-3 percent range. The CPI increased by 2.9 percent
in the first seven months of 2009, with two percent of the
increase coming in June and July alone. While a significant
amount of the July CPI figure was due to one-off items
intended to increase tax revenues such as the one percent
increase in VAT and increased taxes on cigarettes and cars,
the Bank noted in its announcement that inflation was close
to the upper end of the range. The Bank acknowledges the
difficulty of trying to balance inflation control with the
need to increase economic activity, especially as
unemployment is expected to climb further in the next few
months. However, they believe that the 0.75 percent interest
rate strikes this balance.


3. (C) Some in the business sector, notably Shraga Brosh,
President of the Manufacturers' Association, criticized the
decision to raise rates, opining that the harm caused by even
a slightly higher rate to Israeli exports, growth and jobs
far outweighs negligible inflation. Others praised the
action, noting the relatively mild recession in Israeli and
the combination of improving growth alongside developing
inflation. Finance Minister Yuval Steinitz, in an August 25
radio interview, said that the rate increase was logical and
expected, but did not warrant such avid attention as its
impact on exchange rates, growth and employment will be
minimal. In an August 20 meeting with Econoffs and Treasury
rep, Dr. Akiva Offenbacher, the Director of Monetary Policy
at the BoI, also noted that the timing of a rate hike was
rather immaterial. He does not view inflation as a concern
for the next year to 18 months, and opined that the interest
rate would be increased further. While the BoI has given no
formal hint as to whether it will continue to raise rates,
expectations (the recent strengthening of the shekel this
week) clearly favor another hike before the end of the year.
However, this will depend on CPI figures, the exchange rate,
as well as broader global economic trends.

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BoI will continue to bolster the dollar as needed
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4. (C) In recent weeks, the Bank has taken a detour from its
very active involvement in the foreign exchange market, part
of the bank's strategy since March 2008 to bolster the dollar
relative to the shekel. On August 3, the BoI announced it
would continue buying USD 100 million a day in the FX
market, but in addition would intervene in the event of
"unusual movements in the exchange rate which are
inconsistent with underlying economic conditions, or when
conditions in the foreign exchange market are disorderly."
After the announcement and further BoI involvement in the
market, the dollar steadily rose to NIS 3.93. A week later,
the BoI announced it would discontinue the daily USD 100
million purchase, but continue market intervention as needed.
In an August 19 meeting with Econoffs and Treasury rep,
Andrew Abir, Head of the Finance Division's Market Operations
Department at BoI, explained that the Bank is looking to
shift from regular dollar purchases to less transparent or
predictable interventions that will have greater impact on
exchange rates. Some economists noted that the BoI will have
to continue its foreign exchange purchases to the extent that

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it seeks to maintain the weakness of the shekel to support
exporters and economic growth. Industry reporting indicates
that the Bank purchased about USD 50 million prior to the
interest rate announcement on August 24 and a similar amount
on August 25. There has also been strong criticism of the
Bank's intervention policy, with some economists concerned
about potential inflationary side effects and others simply
opposed to the idea of the BoI aspiring to influence the
dollar/shekel rate.

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The Economy Appears to Rebound
--------------


5. (SBU) GDP grew by one percent in the second quarter,
after two quarters of contraction. The primary drivers of
growth were private and public consumption, which grew by 4.4
percent and 20.2 percent respectively. The sharp increase in
public consumption follows a decline of 5.6 percent in the
first quarter, with public spending capped at one-twelfth of
the 2008 budget per month in the first months of 2009, due to
lack of an approved budget. Exports increased by 5.8 percent
in the second quarter after declining sharply by 36.2 percent
in the fourth quarter of 2008 and by 27.2 percent in the
first quarter of 2009. Although the overall picture is
positive, there are a few components that buck the trend and
make it difficult to define the extent of the return to
economic growth. GDP per capita remained negative in the
second quarter, although declining less than the first
quarter. Domestic investment continued the decline of the
previous four quarters. Investment in fixed assets
registered a decline of 10.3 percent in the second quarter,
following a decline of 11 percent in the first quarter of

2009.


6. (SBU) The Bank of Israel's State-of-the-Economy Index
(S-index),which is an indicator of business activity, rose
by 1.2 percent in July. The indices of May and June were
adjusted upwards, and were the first positive indices since
June 2008. All components show positive trends --
manufacturing, trade and services, service exports, goods
exports, and imports -- indicating "a turnaround reflected in
an increase in economic activity" according to the BoI. Bank
Hapoalim's consumer index rose in July for the fourth
consecutive month, which the bank's economists attribute to
the rebounding of the financial markets and a low interest
rate encouraging consumption and asset purchasing. Housing
statistics indicate a return to real estate purchases, and
the leading index of the Tel Aviv Stock Exchange (TASE),the
TA 25, has increased 53 per cent since January 2009. On
August 25, the TA 25 exceeded the 1,000 mark for the first
time since the collapse of Lehman Brothers in September 2009.


7. (SBU) Unemployment statistics for the second quarter,
released August 27, show an increase from 7.6 percent in the
first quarter to 8 percent. While several economists and
contacts at the Ministry of Finance are disturbed by the
trend, they all noted the lagging nature of unemployment and
expect that by year's end the gains in the larger economy
will also be evident in the labor market.


8. (SBU) Assessments of the current state of the economy
from local leading commentators highlight the relative
mildness/brevity of the domestic recession due to Israel's
strong underlying fundamentals, but many caution that the
strength of the local recovery will depend heavily on a
global recovery. Optimism prevails, with2010 GDP growth
forecasts ranging between 2-3 pecent, powered by a rise in
high tech exports as ell as sustained consumption and
government spending. Finance Minister Steinitz and his
Director General presented an economic survey to the cabinet
on August 23, the first in a new series of regular quarterly
surveys. The Minister cited several government actions that
served to bolster the economy -- formulation of an economic
plan, approval of a two-year budget, a package deal between
the government and the labor federation, Histadrut -- and
noted the positive benefit of stability that these actions
contributed to recent economic improvements. He also cited
the effect of guarantees to exporters, bank guarantees,
credit funds to SMEs, as well as billions of shekels of
government investment in infrastructure and R&D. He warned
of the need to maintain budget discipline if true growth is
to return, noting the increasing debt-to-GDP ratio, which is
forecast at 84 percent for 2009.


9. (C) Comment: Timing aside, the interest rate increase
was largely expected and confirms continued activism by Bank

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of Israel. Maintaining the balancing act of curbing
inflation while also keeping the shekel weak enough to boost
exports will require continuing intervention, but Bank of
Israel officials privately indicated to Econoffs and Treasury
rep that they do foresee enough signs of recovery by the end
of the year to cease constant intervention in the foreign
exchange market. The recently published national accounts
data provide everyone with a victory to crow over, bolstering
the Finance Minister's job approval ratings as well as those
of the Prime Minister. With the lull provided by the
two-year budget, there is time for the fiscal due diligence
that the Finance Minister encourages. Many of our contacts
in the Prime Minister's National Economic Council, the Bank
of Israel, and the Ministry of Finance are hard at work on a
consensus formula for a new fiscal rule that will ensure the
necessary discipline (septel).


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