High probability of rising inflation expectations
The risks of inflation continue to increase. We have updated the 12-month inflation forecast to 3.0%. We raised the forecast for the February index by 0.1% following the expectation of higher prices for flights abroad with the removal of restrictions by the government. The forecast for the price index for March also rose by 0.1% to 0.6% in light of the expected rise in fuel prices.
Expectations of a rise in the Bank of Israel’s interest rate, especially after its announcement last week, have led to a drop in inflation expectations. In our opinion, at this stage, there is no justification for this for the following reasons:
There is a reasonable risk that the Bank of Israel, like most of the central banks in the world, is “behind the curve” and begins to raise interest rates too late. The gap between the level of interest rates and the inflation rate, which currently stands at minus 3%, is almost the lowest ever, which raises the risk of accelerating inflation, especially against the background of rapid economic growth and a significant rise in commodity prices. Recall that since expectations of rising Fed interest rates began to rise in October, inflation expectations for two years have risen from 2.5% to 4% and for 5 years from 2.5% to 3.1%.
In the last two episodes of the rise in the Bank of Israel’s interest rates in 2009-2011 and 2005-2006, there was almost no decline in inflation expectations over the period of rising interest rates, although then conditions more supported the decline in inflation than now.
Recall that in 2005 the interest rate began to rise when it was already higher than the inflation rate, which was below 2%. During the rise in interest rates from 3.5% to 5.5%, the inflation rate continued to rise to 4% before starting to fall. In the years 2009-2011, the interest rate rose from 0.5% to 3.25%, while the inflation rate rose from 3.5% to 4%. It was only after the outbreak of social protest in 2011 that inflation began to decline.
Although previous events show that it is not so easy to beat inflation, the market embodies that the interest rate at zero level will rise by 1.5% -1.75% and that will be enough to suppress the inflation which in April is expected to reach 3.4% in reality anything can materialize, but keep in mind that Never happened before.
Commodity prices have risen in shekel terms since the beginning of the year by a sharp rate, from 13% in the price of wheat to 45% in the price of coal. In February alone, commodity prices rose in shekel terms by between 6% and 13%
Short-term inflation expectations in Israel are significantly lower than expectations in the United States and Europe after a sharp rise in them against the background of recent events.
The Bottom Line: In our view, at this stage there is no basis for a decline in inflation expectations based on forecasts of rising interest rates. In current inflation expectations, indexed bonds are still a better alternative to shekel bonds.