US embassy cable - 05TELAVIV5892

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