Rafi Gozlan, Chief Economist, THERE Investment house
Although inflation is expected to approach the upper limit of the target in the coming quarter, it will decline in the second half of the year.
The consumer price index for December rose by 0.3%, completing an increase of 2.8% in 2021. The December index surprised upwards (consensus 0.1%), after a downward surprise in the previous two indices. Although the rate of inflation in 2021 is the highest since 2011, inflation in Israel continues to move around the lower end of world inflation.
The main contribution to the rise in the index in December came from the housing section, with an increase of 0.8% and a contribution of 0.2% to the general index. This increase included a high one-time contribution of 0.12% to the index as a result of the increase in the purchase tax on residential real estate investors, and the balance is a 0.4% increase in the owner-occupied housing item, which reflected a further acceleration in the annual rate from 2.9% in November to 3.3% in December. .
An examination of the monthly change in the section on prices of owner-occupied dwellings in 2021 shows that the seasonal effects were maintained throughout most months of the year except January and November. Since the sample in these months is more limited relative to the summer months, it is too early to determine that the rate of increase was based on higher levels. Although the increase in the price of owner-occupied dwellings is consistent with the improvement in the labor market during the second half of 2021, a sustained increase beyond these rates should be supported by a further acceleration in the wage increase, while according to the analysis presented by the Bank of Israel. . This is also reinforced by the rent index, which continues to reflect a significantly lower rate than that of the owner-occupied housing item, and in December rose 0.1% and completed a 1.1% increase in the past year. Our inflation forecast for the coming year assumes rates of increase of about 3.5% -3.0% in the housing section.
Apart from the housing item, a contribution to the rise in the index in December was also made from the food item and the effect of disruptions in the supply chain. The food item rose 0.5%, completing a 3.5% increase in the past year. Beyond this increase, in recent weeks the rhetoric around further increases, especially on the part of Osem, has been renewed, and this is expected to be reflected, albeit moderately from the statements, in the coming indices. The rise in food prices reflects an effect in the lagging behind the rise in agricultural commodity prices, but the rise of these was halted throughout the second half of 2021, so the intensity of the further rise in food prices is expected to be more moderate than that recorded in the past year. Also, beyond the media protest, credit card data in recent months indicate a decline in sales in food chains, so a further price increase under these conditions is not trivial, and if it does materialize is expected to be relatively moderate.
The rise in car prices continued in December as well. Car prices recorded an increase of 1.2%, completing an increase of about 8% in the last year, mostly in the second half of 2021. Beyond the contribution due to global disruptions, the price increase was also supported by a local factor (delay in approving new licensing groups) resolved in recent days. To moderate the rate of increase in vehicle prices over the coming months.
Also, the rise in raw material prices and high transportation prices pushed for a further rise in furniture prices in December, but with a negligible contribution to the index. In contrast, the rise in home appliances prices has moderated in recent months. In our opinion, the upward trend in the prices of industrial and sustainable products will be halted during the coming year both by the gradual improvement in the supply chain and a decrease in the transport price and as a result of a return to a more normal pattern of consumption.
The effects of the opening of the economy on inflation continued to moderate in December as well, so that in recent months the rise in the prices of events and cultural and sports events has been halted. In terms of holiday prices, there has been a seasonal moderation in local prices in recent months, but they are still about 8% higher than their level in December last year. The item on expenses for travel abroad rose surprisingly in December (at a slight rate of 0.1%), despite the sharp decline in trips abroad following the spread of the omicron. In our opinion, it is likely that most of the moderating effect on flight prices will be felt in the next two indices. Also, some offsetting for increases in the December index came from a fall in fuel prices (if there is no change in oil prices by the end of the month they are expected to rise back in the February index), and a fall in fruit and vegetable prices. In addition, the seasonal contribution from the apparel and footwear section was relatively moderate, reflecting the effects of the appreciation, particularly against the background of the industry’s high exposure to direct shopping from abroad.
Inflation of 1.6% in 2022-The inflation mix is expected to change later this year
An examination of inflation in 2021 shows that most of it was imported, against the background of rising commodity prices and supply chain disruptions, with only recently a higher contribution from the housing section. The following table shows the items with the most significant contribution to the rise in the index in the past year, from which the high contribution of rising commodity prices (food and fuels, about 1% cumulative to the general index), supply chain disruptions (cars and furniture and household equipment, about 0.7% to the general index) The effects of opening up the economy were added (mainly local vacations and parties and events, items whose contribution has moderated in recent months, and in 2021 amounted to about 0.2% of the general index). In addition, a high one-time contribution was recorded from the tax increases (one-time tools and purchase tax), which in the last two indices amounted to about 0.3%.
Looking ahead, the inflation mix in the coming months is still expected to reflect the lagging effects of rising commodity prices and supply chain disruptions, alongside the higher contribution from the housing section. However, the impact of these factors is expected to moderate gradually: the sharp appreciation of the shekel in recent months, a stabilization in agricultural commodity prices, halting the deterioration in the supply chain and, above all, a change in Fed policy that is expected to moderate global demand. In addition, from the second half of the year into 2023, recently approved import reforms are expected to be gradually phased out. Thus, our inflation forecast for the coming year was 1.6%, but most of the increase is expected in the coming months, while the second half is expected to be characterized by significantly lower rates than those that characterized 2021.
The domestic market is again betting on raising interest rates, but most of the increase is expected in real interest rates rather than nominal
Over the past week, the rise in expectations for raising local interest rates has resumed. This is after the downward surprises in the previous two indices, and the ionic tone that characterized interest rate decisions and the strengthening of the shekel, led to a disengagement between domestic expectations and those in the US in the last two months. On the other hand, the makam market embodies zero interest in the coming year, but this is mainly for technical reasons that stem from the interest rate differentials between cash interest rates and interest rates in shekel-dollar contracts. Yields on two-year government bonds, around 0.25%, embody a risk premium that reflects an expectation of an interest rate increase, but at a significantly moderate rate than that derived in the same range from the interbank market (yield of 0.5%).
The renewed expectation of a rise in the local interest rate was supported by an increase in expectations of a rise in the US interest rate in parallel with a rise in inflation expectations in Israel. Over the last few days, the Fed’s position on the issue of raising interest rates has become clearer, so the probability of starting the process of raising interest rates in March is very high, and the market embodies close to 4 increases by the end of the year, to around 1%. Powell also hinted that a decision to reduce the balance sheet would be made within 2-4 meetings, thus signaling the potential for the beginning of the balance sheet reduction towards the middle of the year.
The signal for a move to a monetary contraction is ultimately aimed at raising real interest rates. Because US inflation expectations are still high, the rise in yields so far has translated into rising real interest rates along the curve, but they are still in deep negative territory. The U.S., which has gained momentum recently, is still very far from finishing.
In Israel, the rise in interest rate expectations has resumed despite a clear position expressed by the Bank of Israel (and in particular the Governor’s statement that Israel is elsewhere in terms of inflation), which means a long wait for examining developments in the global economy and domestic inflation. For, the Bank of Israel’s assessment, of which we are a partner, is that the inflation mix recorded in the past year and based on imported inflation may indeed characterize the coming period but will subside later in the year. Accordingly, the Research Department’s inflation forecast for 2022 stands at 1.6%. Our inflation forecast is the same as the Bank’s, and in fact it is expected that in the coming quarter inflation will move around the upper limit of the target (3%), but from there it will gradually moderate towards the middle of the target and below during the second half of the year.
This assessment, when in the background the Bank is struggling with the strengthening of the shekel, constitutes a mix that does not force the Bank of Israel to follow the Fed. In our estimation, in order for interest rates in Israel to rise during the coming year, the inflation environment, in practice and expectations, must remain around the middle of the target (2%) or higher during the year, while there is no deterioration in the macro picture and financial conditions. Also, the more determined the Fed is to return US inflation to its target, the more likely it is to tighten financial conditions, slow down demand and lower commodity prices, ie to reduce inflation imported into Israel. This scenario will significantly reduce the potential for raising interest rates in Israel. The analysis shows that the emphasis on an increase in the interest rate environment is actually in the real interest rate in Israel, which is in a deep negative trot of about 2.5% – mainly due to the expectation of a decline in the inflation environment At the nominal interest rate.
This scenario places the CPI-linked bonds with a high potential for capital losses later in the year. Beyond the expectation of a rise in the real interest rate, inflation expectations continue to embody a very high inflation risk premium, especially in the medium term. Despite the relatively low inflation in Israel over the past year, inflation expectations continue to be significantly higher than those in the eurozone, although the inflation environment in Europe is more relevant to Israel than in the US. Our assessment is that in the coming year the linked channel is expected to perform poorly in relation to the shekel channel, especially in the medium and long term.
Also, despite rising expectations of raising local interest rates and flattening the curves around the world, the local curve remains very steep, so the long sections, especially for 30 years, continue to be characterized by attractive pricing. In our opinion, it is worthwhile to take advantage of the volatility and the rise in yields in these parts to extend the MHM until the yield and steepness gap with the United States is reduced.