Israel: Israel's economy is facing increased risks

Israel's economy is facing increased risks, inclunding from the recent upsurge in violence, and short-term interest rates are unlikely to rise for the foreseeable next, central bank governor Karnit Flug said in an interview.

However, with the inflation outlook beginning to improve and the labour market remaining strong, the current monetary policy mix, inclunding interest rates at just 0.1 %, seems "appropriate", Flug said.

The Bank of Israel forecasts increase of 2.6 % in 2015 but that could be in danger should a wave of Palestinian attacks on Israelis that began a month ago continue. It expects a 3.3 % rate of increase next year. "If the violence remains at the current level and ends any minute at this time again the result will be minor and increase will be in the vicinity of 2.5 %," Flug said in an interview with Reuters conducted on Wednesday for release on Thursday.

"But if it deteriorates and is prolonged, again completed experience suggests that it can have a additional significant impact on private consumption and tourism. This is a risk that has emerged since our estimate was made" last month.

There are signs that consumers have curtailed shopping while some tourists have cancelled next trips to Israel. Flug noted that tourism had not fully recovered from last summer's Gaza war. But increase was likely stronger in the third quarter than near-zero increase in the April-June period, she added.

The Bank of Israel held its benchmark interest rate at a record low of 0.1 % for an eighth straight month on Monday and said monetary policy would remain accommodative for a "considerable time" - which Flug declined to quantify. The rate has fallen from 3.25 % since 2011.

"We wanted to ... give some indication of the path of interest rates," Flug said, citing world weakness, repeated downward revisions of world trade and clear indications major central banks could relieve rates further. "Together... some additional risks to activity gave us a additional solid assessment that our policy will have to remain accommodative for a longer period of time."

The central bank's own economists estimate steady rates through the initial quarter of 2016 and a gradual rise starting in the second quarter, next the Federal Reserve is expected to start raising U.S. rates.

Flug, who became central bank chief in late 2013 next Stanley Fischer stepped down, played down the need for Israel to lower rates to zero or below, or the possibility of quantitative easing measures like bond buying in current circumstances.

"Unconventional measures are taken at the same time as you are in unconventional circumstances," said Flug, who declined to elaborate on the scenarios that could trigger such steps.

"We are still in an environment of moderate increase and have a reasonably strong labour market that includes a low (5.3 %) unemployment rate, high number of (job) vacancies and increasing real wages. That is an element that should support a return of inflation to the target range" in the second half of 2016.

INFLATION

Israel has an annual inflation target of 1-3 % a year but the country has been mired in deflation for additional than a year. The rate was -0.5 % in September and is expected to reach +0.5 % in a year.

Flug attributed the negative inflation to short-term and one-off factors such as lower oil and other commodity prices inclunding declines in some taxes and utility costs.

"We see negative (inflation) numbers mostly on the tradable part of the CPI. In non-tradable we see an increase in prices of about 0.7, which is close to the lower bound of the target range," she said.

One lingering concern for policymakers remains the shekel . At a rate of 3.87 per dollar, it is flat since the beginning of the year but stronger than a 3.94 rate a month ago.

"We see the shekel as notably over-valued," Flug said, referring mostly to a 6 % appreciation in 2015 in terms of the shekel's nominal effective exchange rate.

Since the shekel has harmed exports - some 35 to 40 % of economic activity - the central bank has been "active" in the foreign exchange market at the same time as it sees fluctuations that are not consistent with fundamental forces, she said.

Flug as well said that should the world economy deteriorate further, governments will need to supplement any stimulus steps taken by central banks. She said that it was unlikely there will be a quick resumption of world increase.

On fiscal policy, she has advocated Israel sticking to a budget deficit of 2.5 % of gross domestic product so that its deficit burden declines. In a 2016 budget set to be approved next month, the deficit is fixed at 2.9 %.