The interest gap is closing

With the US Federal Reserve interest rate down to 0-0.25%, there is little room left for maneuver for interest rate policy in the US, to help revive the American economy. In Israel, on the other hand, with interest holding at 1.75%, there was still a way to go. However, on 26 January, the Bank of Israel announced its decision to reduce interest further – to 1%, thus narrowing the interest gap between the US and Israel. Will it be narrowed further? We will have to wait a month to see.

This is the 6th interest reduction in Israel since September 2008, when interest stood at 4.25%: at the same time, the US Fed interest rate was a much lower 2%. The recent process of interest rate reduction has therefore been much more dramatic in Israel than in the US: since September, interest in Israel has fallen by 3.25% (from 4.25% to the current 1%) while in the US, the reduction has been 1.75-2%. So the narrowing of the interest gap between Israel and the US has been going on now for several months.

The concern in Israel – and the rationale for the interest rate reductions – has been the same as in the US: the slowdown in the economy and the strong possibility that the slowdown will turn into a recession (a period of negative GDP growth). This is already accepted in the US but now it is also accepted by the Bank of Israel. In July 2008, the Bank published a forecast of 3.4% growth in 2009. This was reduced to 3.1% in August, to 2.7% in October and to 1.5% in November.

Just one day before its most recent interest rate decision, the Bank published is latest 2009 growth forecast according to which the Israeli economy will be in recession in 2009, with negative growth of -0.2% (see our blog of 14 January – "Growth forecasts for 2009 keep getting reduced"). The performance of the economy in 2009 may well turn out to be even worse than this.

Will the interest rate reductions work, helping to revive the Israeli economy? In the press statement that accompanied the reduction of interest to 1%, the Bank of Israel complained – not for the first time – that interest rate reductions by the central bank since September have not been followed by similar reductions implemented by the commercial banking sector and that the commercial banks have not eased up on the credit crunch.

This of course is what has to happen if the reduction in interest is to work. The central bank cannot force the commercial banks to lower interest when it lowers interest, but in the past, commercial interest has generally followed central bank interest closely. The commercial banks argue that since interest payments constitute a major part of their income, lowering interest too much could jeopardize their stability.

However much the Bank of Israel would want to avoid this possibility (especially in view of the collapse of major banks in the US and elsewhere), the banks' argument is not regarded as satisfactory by the Bank of Israel. The counter argument is that it is in the commercial banks' own interest to do everything possible to help revive the economy.

Central bank Governor Stanley Fischer announced that if the commercial banks do not come through of their own volition and lower interest, he will have no choice but to implement (perhaps regulatory) measures to make them do so. Everyone is now waiting to see what these measures could be.

The amazing case of housing prices

The global economy is in recession – probably the worst since the Great Depression that began in 1929 – and the Israeli economy has been dragged in to the crisis. A major feature of the recession is the real estate slump, which began with the sub-prime mortgage crisis, and one of the main features of this slump is a sharp fall in housing prices in many countries around the world – except, it seems, for Israel.

Since mid-2008, housing prices in Israel have been increasing significantly, even though the demand for housing is clearly weak, as is to be expected in a severe economic slowdown. Here are the facts: during the second half of 2008, the total Consumer Price Index (CPI) increased by a monthly average of 0.2%, while the housing price component of the index increased by 2.2%, on average. During the final four months of 2008, the total index declined by 0.6%, while housing prices increased by 7%. Preliminary forecasts for December were that the total CPI would decline by as much as it did in November (-0.6%: the December CPI was published on 15 January), but it declined in fact only by 0.1% - the main reason: a 1.7% increase in housing prices in December.

What is the explanation for this strange behavior of housing prices in Israel? One explanation brought forward is that it is connected with the transfer of real estate transactions from dollar-denominated to shekel-denominated. For most of Israel's history, housing prices (both rental and purchase) have been denominated in dollars, but when the shekel began strengthening against the dollar, a process that began in 2006 and continued during 2007 and 2008, sellers/renters of real estate began to realize that they were losing money and began to denominate prices in shekels.

It seems that the translation of housing prices from dollars to shekels more than compensated for the loss of value of the dollar against the shekel (sellers/renters sought compensation for the accumulated loss as a result of the continuing weakening of the dollar against the shekel), so that housing prices increased in shekel terms even though real estate demand was weak. For some – not very clear – reason, purchasers/rentees went along with this and allowed housing prices to increase.

But this transfer process from dollar-prices to shekel-prices had more or less worked itself through by mid-2008 (according to official data, the share of new rental contracts denominated in shekels increased from 34.7% in December 2007 to 74.4% in July 2008, and then trickled up to 81.5% in December 2008), and it is not clear that it explains the rapid increase in housing prices in the second half of 2008.

Another possibility is that the recent housing price increase is a result of increasing prices of construction inputs. But even though the price index of inputs to residential construction did increase by 1.1% during the 3^rd quarter of 2008, it declined by 2.1% during the 4^th quarter: so this is not the explanation.

One other simplistic explanation is that the Central Bureau of Statistics does not measure housing prices correctly within the total CPI: this claim has indeed often been made in the past.

All we can say at the present time is that there is no really satisfactory explanation, at the present time, of the recent increase in housing prices. But we are prepared to forecast that housing prices will decline during the first half of 2009, as the weak demand for housing kicks in.

Growth forecasts for 2009 keep getting reduced

They began at close to 3%, were then revised down to 1.5% and are now reduced further to 0%. We're talking about growth of GDP forecasts for the Israeli economy in 2009. These are international forecasts – the "close to 3%" and "revised down to 1.5%" forecasts belong to the International Monetary Fund (IMF) while the 0% forecast was recently published by Merrill Lynch.

But local forecasts are not that different: the Bank of Israel, which also revised its 2009 growth forecast down to 1.5%, recently announced that it soon intends to reduce it further. Local forecasts are essential for the 2009 State Budget, which will only be approved once a new government is formed after the February 10 general election (because of the Gaza offensive, there is no absolute certainty that the election will take place on 10 February, so approval of the 2009 budget may be delayed even more).

Every State Budget has a growth forecast built into it, which is the basis for calculating expected tax revenues, which in turn are taken into account in determining the targeted budget deficit - and everyone knows the importance of the budget deficit in establishing an economy's credentials, both internally and internationally.

The 2008 budget deficit, published on 13 January 2009 by the Ministry of Finance, is already a cause of initial concern in this area. After declining steadily from 2004 to 2007 while the economy grew rapidly, the deficit increased from 0% of GDP in 2007 to 2.1% of GDP in 2008, 3.8 billion shekels (1/2% of GDP) above target. The main factor here: the below-target tax revenues during 2008 (total real tax revenues declined by 7.7% compared to 2007), a direct result of the developing economic slowdown. If the much slower forecast 2009 growth materializes, tax revenues will continue to decline in 2009 (as indeed most analysts expect them to do), causing a much bigger budget deficit headache.

There are two questions about the revised 2009 growth forecasts. Firstly, they appear to close the growth rate gap between Israel and other developed economies, for which the 2009 growth picture is also very dismal (with several forecast to experience negative growth), while the gap in 2008 was quite significant. It is true that estimates of Israeli GDP growth in 2008 were recently revised down from 4.5% to 4.1% (compared to more than 5% annually in 2004-2007), and are quite likely to be revised down further – to below 4% - as data for the final months of 2008 become available, but this still leaves 2008 growth in Israel significantly faster than in the other developed economies (which grew at 1% or less in 2008). The question is: why will the growth rate gap narrow in 2009?

The second question is, referring to both the global and Israeli economies: when will the recovery from the current slump begin? Few analysts argue that it will begin during 2009, most claim that at the earliest, the recovery will start in 2010 and will be very slow. An additional relevant question regarding the Israeli economy is: can a recovery in Israel begin independently of the recovery in the global economy. In a recent statement, Professor Stanley Fischer, Governor of the Bank of Israel, maintained that an Israeli recovery is highly dependent on the global recovery.

Just as recently, a poll of a group of senior economists in the US reported that based on growth patterns in previous severe economic crises, the current recession is likely to be deep and continue for anywhere from 2 to 5 years.

If we take together the expected length and depth of the current global economic crisis and Israel's dependence on the global economy, it is not difficult to appreciate why 2009 growth forecasts for Israel are being revised down all the time and why the gap in growth rates is likely to narrow significantly in 2009.

Even though there are some optimists who argue that we will see the start of a recovery in Israel during 2009, the consensus is that however glad we were to see the end of 2008, 2009 is most likely to be an even harder year for the Israeli economy.

The Gaza Offensive and the economy

Since the Gaza offensive began on 27 December, there has been much rhetoric and media coverage about the possible effects of the offensive on the Israeli economy. If we look at periods of military conflict in the recent past, we can report that the effect of the 2nd Lebanon War in July-August 2006 on the economy was minimal – just a short-term slowdown on GDP growth and a surprisingly limited effect on incoming tourism. But all this may have been because at the time, the Israeli economy was in the midst of a rapid growth period.

At present, the economy is showing signs of significant slowdown, as part of the overall global slowdown/recession. Is it possible that the effect of the Gaza offensive will be heightened as a result of these different economic background conditions? Our answer to this is: no.

Firstly, on the assumption that the slowdown will continue during (at least the first half of) 2009, we will have no real way of isolating the effect of the offensive on the economy from the general trend of slower activity, resulting from the global crisis.

Secondly, there is consensus that the slowdown in the Israeli economy is lagging the global slowdown so the downward trend in economic activity in Israel still has a way to go, regardless of the possible effect of the Gaza offensive. Recent data indeed show how the economic situation in Israel is deteriorating. Revised estimates of GDP growth in 2008, published on 31 December, show a more severe slowdown than that shown by preliminary estimates, published in October – 4.1% compared to 4.5%. 3rd quarter GDP growth slowed to just 2.3% (these data were published in November and undoubtedly contributed to the revised annual growth estimates).

Consumer confidence in Israel took a steep dive in December. The Bank of Israel again lowered interest rates sharply at the end of December (in line with interest rate slashes by central banks around the world), as a way of contending with the worsening slowdown. Revised IMF growth forecasts for 2009, published in November, show the Israel economy growing at just 1.5%, compared to an earlier (October) forecast for Israeli growth of 2.8% in 2009.

All this is happening without the influence of the Gaza offensive, and it is unlikely that the offensive will add significantly to these downward trends. Could incoming tourism be affected by the offensive? Based on the experience of the 2nd Lebanon War, the effect – if at all - is likely to be limited. It is worth noting that incoming tourism increased significantly throughout 2008: if it begins receding in 2009, it is more likely that this will be the result of the global slowdown affecting tourism in general around the world, rather than the result of the Gaza offensive.

One possible cause for concern is the effect of the offensive on the Israeli budget deficit in 2009, given the decline in tax revenues (a major feature of 2008) as a result of the economic slowdown, which is expected to continue in 2009. While other countries have decided to increase budget deficits as a fiscal way of dealing with the global crisis, the Israeli government has for the moment withstood pressure to go down the same path. The possibility of increased defense expenditure as a result of the Gaza offensive may make this target more difficult to achieve, though most defense sector experts argue that the offensive will not call for any increase in the defense budget.

The effect of the Gaza offensive on the economy depends of course on how long the offensive will continue and at the present time, with the offensive having just begun, there is as yet no answer to this question. So we will most likely be reporting here on this subject in the months ahead.