Bank of Israel on hold, worried about ILS strength, deflation, and tepid growth

The Bank of Israel (BoI) kept its 0.10% base rate on hold, as expected. It is believed that, BoI has no appetite to loosen monetary policy under the current circumstance even though it remains concerned about the very low inflation level, weakening growth, and ILS appreciation. Instead, the BoI appears to be prepared to keep its historically low base rate at 0.10% for an extended period, until inflation rises into the 1-3% target.

The BoI noted that inflation at -0.5% y/y in September is extremely low, and the prospects are that in the next few months it will push even lower given government policies. One-off factors in September that were responsible for the further descent into deflation include cancellation of the television fee and the cut in electricity prices, along with accelerated decline in fuel prices in the background. In the next two months, the 1% cut in the VAT rate and continuing effects of the electricity price cut are expected to reduce CPI further. With medium-term inflation expectations in the target range, the BoI is not overly concerned about inflation. However, it notes in the important last paragraph of the statement that "risks to achieving the inflation target remain high".

As to growth, the BoI reserves a special kind of ambiguous language to describe trends. It notes that the increased violence in Israel and the occupied territories has had a negative effect on consumption and tourism, maintaining that this effect will likely be temporary. It notes with concern that exports and imports of goods declined in September. As an offset, the Companies Survey has held steady, employment indicators continue to improve, and tax collection has increased substantially in 2015. Nevertheless, the BoI concludes that "risks to growth have increased".

The BoI appears to be particularly concerned about the economic impact of ILS strength. The statement notes the ILS appreciated last month, and the cumulative appreciation this year is 5.9%. As per the statement, this "is weighing on growth of exports and the tradable sector, and is delaying the return of inflation to within the target range".

The BoI's reluctance to take additional action in easing monetary policy further despite worries about deflation and growth has been disappointing to the market. Also missing from the BoI's statement was any mention about stepping up FX interventions in the face of ILS's stubborn strength. The ILS has appreciated about 60bp on the day, potentially reflecting market pre-positioning for a dovish BoI statement.

"We believe the passive approach by the BoI of maintaining low rates will only slowly weaken the ILS over time and will be largely driven by broad USD strength. Although expectations of a Fed lift-off remain under-priced by markets, a near-term trigger appears to be data-dependent - we see some downside risks to our forecast for USDILS 4.00 by year-end 2015 but remain comfortable with the medium-term forecast of 4.14 in Q2 16. We continue to be long USDILS spot", says Barclays.