The Bank of Israel has proven once again that for it, if there is any doubt, there is no doubt. The circumstances supported the continuation of the interest rate cut and it did not delay. Inflation below target and a decline in inflation expectations, the economic slowdown that existed even before the war while inhibiting improvement in the labor market, uneven and fragile growth in the world and of course the war in Gaza led to an immediate interest rate cut. Two interest rate cuts in a row show that from the Bank of Israel's perspective, the economy's situation is dire.
The impact of the last two interest rate cuts on economic activity in the economy is expected to be smaller than the previous cuts. As interest rates approach zero, banks do not pass on the full interest rate cut to customers who pay mandatory interest, in order to maintain the interest margin. As evidence, credit in the economy, especially business credit, is stagnant despite the interest rate cuts. The Israeli economy is in a liquidity trap, with the price of money not affecting the demand for money and the growth in loans.
The Bank of Israel must hope that the economic slowdown is strong enough so that demand in the housing market will not arise either "naturally" or with the help of the zero VAT law. Otherwise, the zero interest rate will once again drive up apartment prices against the backdrop of a significant decline in construction starts.
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The shekel was immediately affected by the interest rate cut, but it was not only the narrowing of interest rate gaps that caused the shekel to depreciate. The devaluation began almost two weeks after the interest rate cut at the end of July. The continuation of the war, the state of the economy, concerns about the deficit, and an increase in the BASIS SWAP caused a change in the exchange rate trend, which all the interest rate cuts made by the Bank of Israel in the past two years failed to do.
The markets don't really believe in the impact of interest rates on rising inflation. Judging by the reactions to interest rate cuts, including the latest one, implicit inflation expectations have only been decreasing.
Bond market
The immediate and certain impact of the interest rate cut is occurring in the bond market. After short-term interest rate differentials between Israel and the US have fallen to zero or negative levels, long-term interest rate differentials are also approaching zero (see Figure 2). The interest rate cut is pushing investors to take risks, particularly in the corporate bond market.
Based on the experience of other countries around the world that have lowered interest rates to a similar level, long-term bond yields are expected to continue to decline. Among countries where interest rates are at a similar level, including countries with a lower credit rating than Israel, the 10-year yield in Israel is the highest (see Figure 1).
There is only one factor that, under conventional circumstances, should prevent yields from falling. An increase in the deficit, which is expected due to the economic slowdown and increased war-related spending, could threaten Israel's credit rating and lead to an increase in the risk premium. However, today the world's markets are almost insensitive to deficit risk. However, the situation could change in the future.
The Bank of Israel has almost no tools left to deal with a further deterioration in the economic situation. The bond purchase program (QE), as implemented by the Bank of Israel in 2009, will not be effective today. Unlike the period after the global crisis, there is no fear of a liquidity crunch in the financial system today. In addition, bond yields, both in the government and corporate markets, are at a much lower level than in 2009.
After the Bank of Israel has pretty much exhausted its influence, the tools necessary to reverse the negative trend in the economy are in the Ministry of Finance's fiscal policy framework, which it needs to implement in the 2015 budget.
Alex Zabrzynski, Chief Economist, Meitav Dash
