Inflation in the United States is on the rise and it is expected to impact Israel’s economy. The recent release of the Private Consumption Expenditure Index (PCE) data, the preferred inflation index of the Fed, showed that inflation is not decreasing as expected. Instead, it rose to an annual rate of 5.4% in January, up from 5.3% in December.

This latest data release follows the most recent employment report, which came in better than expected. In addition, the CPI, which was published about two weeks ago, exceeded expectations. Based on this data, there is now a good chance that interest rates will continue to rise as the Fed attempts to tame stubbornly high inflation. According to experts, there will be another half-percentage-point increase to 5%-5.25% in March, with overall forecasts for the end of 2023 expected to reach 5.28%.

What does it have to do with Israel?

The expected rise in U.S. interest rates is directly related to the Israeli economy. The increase in interest rates raises the dollar’s exchange rate against a basket of foreign currencies, weakening the shekel, and this is in addition to its recent weakness due to concerns about legal reform.

With most goods imported to Israel denominated in the USD, the strengthening of the dollar may raise the Israeli price index, essentially, resulting in a higher inflation. As a consequence, the Bank of Israel will continue raising interest rates, which have already been the case for eight consecutive months.

In the meantime, the recent weakening of the shekel does not provide comfort to the authorities in Israel. The local currency has fallen by about 9% against the dollar in the last month alone. Although the Bank of Israel has other options for stabilizing the shekel and is thus not required to raise interest rates, experts estimate that the bank will not intervene in the foreign exchange market because market volatility is caused by external factors.

It is worth noting that the bank’s interest rate decisions are also hampered by the tight labor market.

Following the rise in inflation in early 2022 and the Bank of Israel’s commitment to price stability, the bank began to raise interest rates in April. Since then, as previously stated, there have been eight increases at various rates, in the hope that the high interest rate will cool the economy and dampen price increases. Despite this, inflation continued to rise throughout the year, reaching the highest level since 2008.

According to Israel’s CPI data, which was published earlier this month, inflation in Israel continues to rise, reaching 5.4% in January. It appears that current inflation is extremely sticky, which means that the sensitivity of inflation to increases in interest rates is low and that significant monetary measures are required to reduce it. Therefore, at this point, the Bank of Israel will most likely keep raising interest rates until it sees a slowdown and a consequent fall in the inflation rate as its policies begin bearing fruit.

According to analysts, positive U.S. employment data, persistently high inflation, and strong gains in key Wall Street indices since the start of the year all point to further interest rate hikes by the Fed. In Israel, the problem of tight labor combined with the depreciation of the shekel and the rise in inflation expectations all support the Bank of Israel’s stance to pursue continued interest rate hikes.

Clearly, there are some signs of economic improvement, and it is encouraging to see data that supports them. However, these positives are accompanied by sticky inflation, which leads to an increase in interest rate forecasts both in the U.S. and Israel. Therefore, not surprisingly, a stubbornly high level of inflation remains a point of concern not only for policymakers but for markets overall.