US Inflation Surges, Complicating Bank of Israel's Interest Rate Decisions

Inflation in the United States accelerated in September, exceeding economists' forecasts and presenting the Federal Reserve with a renewed dilemma regarding interest rates. The Consumer Price Index (CPI) rose by 0.6% in September, compared to a 0.4% increase in August, bringing the annual inflation rate to 3.7%, above the projected 3.6%. This uptick has intensified concerns that the Fed may need to maintain high interest rates or even implement another hike. The primary driver of the price increases is the rise in energy costs, but inflationary pressures extend beyond fuel.

The core inflation rate, excluding food and energy prices, increased by 0.3% monthly and 3.7% annually, also surpassing expectations. Following the announcement, the dollar strengthened, and yields on U.S. government bonds rose, reflecting market fears of continued monetary tightening by the Fed, which had already raised rates in the previous month. The next interest rate decision from the Fed is anticipated at the end of October.

Yoni Fanning, Chief Strategist at Mizrahi Tefahot Bank, attributed the price hikes significantly to increased oil prices and refining margins for gasoline and diesel. He noted that energy costs impact core inflation through higher transportation and flight prices. However, Fanning suggested that prices might moderate later, as significant portions of the annual inflation accumulated in the past seven months will gradually drop out of the annual calculation, potentially bringing inflation closer to the Fed's 2% target even if energy prices remain high.

Victor Bahar, Chief Economist at Bank Hapoalim, observed that despite the modest upward surprise in the CPI, the market reaction was substantial, leading markets to price in a more hawkish Fed policy. He pointed out that even though the annual core inflation rate of 2.6% is not exceptionally high, the Fed has signaled it will not tolerate inflation persistently above its 2% target. Bahar stated that the market is now anticipating nearly four interest rate hikes in the coming year, with a slight increase in long-term yields.

In contrast to the U.S., Israel is expected to see a different inflation picture, with a projected decrease in its CPI report due in part to seasonal drops in airfare and a reduction in fuel excise tax. Israel's annual inflation is forecast to be around 1.8%, still within the Bank of Israel's target range of 1%-3%. While this might suggest room for further rate cuts by the Bank of Israel, the possibility of additional U.S. rate hikes complicates matters. A widening interest rate differential favoring the U.S. could weaken the Israeli shekel against the dollar, increasing import costs and inflationary pressures in Israel, thereby limiting the Bank of Israel's options for further rate reductions. Fanning noted a recent moderation in the shekel's strengthening trend and a near-elimination of expectations for an interest rate cut in Israel, indicating that U.S. developments may constrain the Bank of Israel's policy space.