Israel Deflation Concerns May Force Central Bank Action

Israel’s falling inflation expectations may force the Bank of Israel to do what it has sought to avoid: take unconventional steps to boost prices.

One-year inflation expectations -- as measured by the yield premium investors demand to hold regular bonds instead of index-linked securities -- dipped below zero in January for the first time since March 2009, the Bank of Israel reported on Jan. 19. After 16 months of negative inflation, expectations for two and five years ahead are also declining.
“The longer there is negative inflation, the higher the risk becomes that inflationary expectations continue to decrease,” said Michael Sarel, a former chief economist at the Finance Ministry who now heads the Kohelet Economic Forum, a research center. “If everyone is convinced there will be deflation, there will be deflation.”

While the bank is reluctant to take unconventional measures for fear of pushing up housing prices, which have doubled since 2007, if “2- or 3-year inflation expectation-rates are negative, or close to zero, then the Bank of Israel will have no choice,” Sarel said.

The central bank, which is due to announce a rate decision on Monday, had no comment on the possibility of implementing unconventional measures.

Central banks from the U.S. to Europe have struggled to revive inflation as oil prices drop and China’s economy slows. The European Central Bank on Thursday held out the prospect of more stimulus as early as March.

Governor Karnit Flug said last month that inflation expectations are “solidly” within target, and that unconventional measures weren’t needed at the time. She didn’t rule them out, however, and in October said they would require “unusual circumstances.”

The bank has historically relied on rate moves and foreign-currency purchases. With the base rate at a record 0.1 percent, it has few conventional tools left to spur prices, which have fallen on slumping energy prices and government measures to cut living costs. Zero or negative rates are one unconventional possibility, and bond-buying is another, analysts said. The bank could also buy foreign currency without soaking up the additional money by selling bonds, Sarel said.

‘Unusual Circumstances’

The Bank of Israel said last month that monetary policy will probably remain accommodative for a “considerable time.” All 21 economists surveyed by Bloomberg predicted the central bank will hold the base interest rate on Monday.

While the Bank of Israel forecasts inflation will return to the government’s target range of 1 percent to 3 percent in early 2017, the market sees things differently.

Inflation expectations for 12 months were -0.1 percent this month. The two-year rate fell to 0.3 percent from 0.5 percent in December and the five-year rate slipped to 1 percent from 1.1 percent. In the past three months, Israel had the steepest decline to its two-year breakeven rate among major sovereign bonds tracked by Bloomberg. The third year is about 0.9 percent, close to the lower end of the central bank’s range, according to Bank of Israel data.

Steepest Decline

A central bank survey of companies published Wednesday indicated a “slight” recovery in the fourth-quarter.  Last month, the central bank forecast 2016 economic growth at 2.8 percent, up from 2.3 percent last year.

Alex Zabezhinsky, chief economist at Meitav DS Investments Ltd., said the Bank of Israel isn’t likely to pare borrowing costs now because there are still signs of reasonable growth.

“The Bank of Israel is also looking at long-term inflation expectations and it’s still satisfied with them for now,” he said. “I think right now the Bank of Israel is not going to do something beyond waiting and watching.”

‘Foreign Pressure’

The global market downturn and reduced bets of U.S. rate increases this year mean the pressure on the central bank to act unconventionally will come from abroad, said Rafi Gozlan, head of research at Israel Brokerage & Investments Ltd.

“Does this mean we are there already, and the central bank will act right now?” Gozlan said. “I wouldn’t say that, but we are slowly moving in that direction.”

What the bank may do is signal it’s preparing to take unconventional steps, and that alone may spur inflation, said Yaniv Hevron, chief economist of Excellence Nessuah Investment House Ltd.

“The next rate decision might bring with it a clear signal of a possibility of a rate cut and steps to address sluggish inflation, if it continues this way,” he said. While a signal may be enough, he said, the central bank may end up cutting rates to zero or below, or buying bonds or foreign currency, he said.

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