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ANALYSIS-Israel c. bank regains credibility with big hike

Published 03/30/2011, 10:43 AM
Updated 03/30/2011, 10:48 AM

* Market was expecting above-target inflation for 5 years

* This week's rate hike bigger than almost all forecasts

* Yield curve flattens a bit in response

* Some switch from inflation-linked to fixed-rate bonds

* But still not clear if more half-point hikes on the way

By Steven Scheer

JERUSALEM, March 30 (Reuters) - Central banks around the world are struggling to regain their inflation-fighting credibility in the face of high commodity prices, but the Bank of Israel may have succeeded -- for now at least -- with an aggressive interest rate hike.

Israel's central bank on Monday raised its benchmark lending rate by a larger-than-expected half a percentage point to 3.0 percent. Virtually all analysts had predicted a third straight quarter-point move from the bank's governor Stanley Fischer.

"The bravest central banker in the world", read a headline in the Haaretz newspaper.

Haaretz columnist Eytal Avriel wrote on Tuesday that Fischer was not the only central banker facing a terrible dilemma between supporting economic growth and keeping a lid on inflation and asset bubbles -- but that he might be more effective than most.

"Many will think Fischer is crazy. But Fischer is simply doing his job properly, uncompromisingly, ignoring political pressure," Avriel said.

"Other central bank governors are the crazy ones. They are keeping interest rates too low and sacrificing the medium and long term for the short term."

In its rate hike statement, the central bank cited a high inflation environment of more than 4 percent and expanding economic activity; the economy grew an annualised 7.7 percent in the fourth quarter of 2010. [ID:nLDE72R1Z6]

"The pre-emptive move to hike rates more than expected will be conducive for restoring the Bank of Israel's credibility," said Kubilay Ozturk, an economist at Deutsche Bank.

"This will also send a good signal to the markets that inflationary expectations will not remain unanchored."

PRESSURE

Before the latest rate increase, the Bank of Israel had already boosted its key rate eight times since August 2009 from a low of 0.5 percent. But as consumer prices started to rise rapidly in the past few months, repeatedly topping analysts' monthly forecasts, many investors believed policymakers were losing the battle with inflation.

Despite the rate hikes, the benchmark 10-year government bond yield rose 30 basis points over the past month, peaking at 5.35 percent on Monday just before the latest rate move. In all, the yield -- a barometer for the inflation outlook -- jumped some 70 bps since the beginning of the year.

That trend was at least temporarily reversed on Tuesday, when the 10-year yield slipped to 5.33 percent, while short-term yields rose to reflect expectations for more rate hikes this year. Most analysts and the Bank of Israel's own model now forecast the key rate rising another percentage point to 4.0 percent by the end of the year. [ID:nLDE72T1KA]

Gil Chen, head bond trader at the IBI brokerage, said there had been heavy selling of inflation-linked bonds in favour of fixed-rate bonds after the Bank of Israel's action.

HSBC economist Jonathan Katz noted that before the latest hike, the market was expecting inflation to exceed the government's target of 1 to 3 percent for the next five years. It is not yet clear how much those expectations are changing; the central bank will next release monthly data on inflation expectations in late April. [ID:nLDE72L0LH]

But Katz said, "People were basically saying that he will consistently miss the inflation target, so he was losing a bit of credibility. I think he has regained that in part."

SHEKEL

Inflation, boosted by housing, energy and food costs, reached an annual rate of 4.2 percent in February and is expected by private analysts to stay around 4 percent for the rest of 2011. [ID:nJES000058]

Fischer had been reluctant to move interest rates more than a quarter-point at a time to prevent rapid appreciation of the shekel , which would damage exports -- more than 40 percent of Israel's econonic activity.

The shekel, currently at a 29-month high of 3.51 per dollar, has moved little since the latest rate hike, largely because of expectations that the central bank could intervene in the market if necessary or authorities could conceivably impose stricter capital controls.

Also, investors are expecting a European Central Bank interest rate hike next week, while the U.S. Federal Reserve might raise rates sooner than originally anticipated.

Analysts are unsure whether Monday's half-point increase in Israel was a one-off event or the start of a trend for the central bank.

But Barclays economist Daniel Hewitt, the lone analyst who had predicted a half-point move this week in a Reuters poll, expects a similar move next month.

"Its gradual rate increases have not been enough to keep inflation under control," he said of quarter-point hikes.

David Lubin, an emerging markets strategist at Citigroup, wrote in a note to clients that the half-point hike "appears to be an admission of failure to some extent and probably leaves the market in a state of confusion about how the bank will pursue its tightening strategy." (Editing by Andrew Torchia)

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