After years of low inflation, inflation in Israel rose to prominence in 2021 amid global bid disruptions, similar to many countries in the world. But unlike some countries in the world that have already begun to raise interest rates, the Bank of Israel boasts a “luxury” in the form of low inflation that does not push decision-makers to raise interest rates. However, inflation expectations derived from the capital market are anchored above the center of the Bank of Israel’s target area, which on the face of it pushes decision-makers to raise interest rates in the economy.
But the rise in inflation has highlighted an interesting phenomenon in the past year in which inflation expectations derived from the capital market for the year ahead have exceeded forecasts projected by market forecasters. Inflation expectations are usually derived from the gap between unindexed and index-linked bonds. In fact, the gap between the Bank of Israel’s and forecasters’ inflation forecast and the “forecast” of indexed bonds reached 1.1% at the end of last October, In terms of inflation expectations.
Significant gap between inflation expectations and market forecasters
If inflation expectations derived from the capital market are very high, then the Bank of Israel should think about raising interest rates before they become a self-fulfilling prophecy. After all, if consumers believe that inflation is expected to rise, then they will want to buy now what may rise in price later, and so the very act will lead to a rise in prices and so on. But there is a significant gap between inflation expectations and forecasters’ forecasts in the market and in the Bank of Israel.
In the Monetary Policy Report of the Bank of Israel for the second half of 2021, an explanation can be found as to why, despite the high expectations of the capital market for inflation, the Bank of Israel is in no hurry to raise interest rates to curb them. According to the theory, inflation expectations can be estimated by calculating the gap between unindexed and index-linked bond yields, but this does not necessarily represent pure inflation expectations but contains additional components, such as inflation risk premiums. Yields between bonds as BREAK EVEN INFLATION without committing that everything is attributed to inflation expectations.
Players are willing to pay an inflation risk premium, the question is how much?
The risk premium actually reflects how much market players are willing to pay for insurance against inflation that is higher than the forecast they estimated. The premium reflects the uncertainty of the investment. If, for example, investors think that the supply chain will continue to be an inflationary factor, this raises inflation expectations.
A negative risk premium reflects a situation where market investors are more afraid of downward surprises in the index. This characterized a period of globalization, the appreciation of the shekel, or, for example, a government policy to reduce the cost of living – a period in which investors were afraid of factors that would lower inflation. In this situation, the investor will prefer to hold an unlinked bond that provides him with a nominal yield anchor and will not want to take on the risk that inflation will surprise downwards. The inflation risk premium became positive in 2021 after being negative in previous years. So why are investors now willing to pay a premium on inflation, does this reflect a lack of confidence in the central bank which estimates that inflation will fall this year and be anchored at the target center in 2023?
According to the Monetary Policy Report for the second half of 2021, the Bank of Israel believes that the rise in inflation expectations from the capital market is largely due to the inflation risk premium, so they can be calm and not fear that the capital market sees something they do not see. According to the Bank of Israel, a significant component of inflation expectations is attributed to the maintenance premium of these bonds, and in fact the “real” forecast for inflation embodied in bonds is lower.
According to the Bank of Israel’s model, after deducting the risk premium, inflation expectations for the year rose to only 1.3% towards the end of 2021, while the market estimated a reading of 2.8%. Bottom line, one can argue with the model presented by the Bank of Israel, but that is not what matters but the fact that the Bank of Israel believes this is the case and therefore the study is an alibi not to raise interest rates.
Victor Behar, director of the economics department at Bank Hapoalim, explains that the premium reflects a situation of asymmetric distribution of the inflation forecast around the average. “After years of low inflation, there has come an event that we can not deduce from the past, but it includes elements that have previously been proven to be inflationary, such as high budget deficits, which are indirectly funded by central banks (money printing). Is that inflation will stabilize near the target center (2% per year), they are willing to pay a premium that will protect them from a higher inflation scenario.This can be illustrated by the example: investors believe inflation will be 2%, but they are much more afraid of a 4% scenario of zero inflation “So they are willing to pay that premium.”
Victor Behar, Head of the Economics Department at Bank Hapoalim / Photo: Inbal Marmari
“By the way, paying the premium wisely turned out in retrospect to be a good idea in the past year, especially in the US, but also in Israel,” Behar added. “If inflation does erupt, there will be no mechanism that erodes government debt.”