At a time when, around the world, financial markets are pricing an exit from the period of high inflation, Israel is moving in the opposite direction. The high cost of the war and the supply problems it has caused, tax hikes expected in 2025, and wage increases, are all pushing prices upwards.
Even the Bank of Israel has had to recognize this, and in its last interest rate announcement forecast inflation running at an annual rate of 3.8% at the end of this year (which compares with a 1-3% target range) and that interest rates would not fall in the near future. In fact, in the past few days, the interest rate market has been pricing in a probability of nearly 50% that there will be an interest rate hike within the next few months.
There is also another factor that is liable to fuel inflation: the public is flocking to cash. The broad monetary aggregate, a Bank of Israel figure that includes all of the cash and short-term investments held by the public (bank current accounts, cash, Bank of Israel short-term securities, bank deposits, and money market funds), shot up by more than 13% between August 2023 and August 2024 to more than two trillion shekels. According to Leader Capital Markets chief economist Jonathan Katz, the trend accelerated in September. "In the past year, we have seen significant growth in this money metric, by some 15%, and it is not expected to moderate any time soon."
The aggregate is at a peak not seen since the Covid pandemic, during which it rose by 25% in 2020 and 15% in 2021. The consequences of that rise were severe: inflation raised its head, and the fight against rising prices lasted two and half years. The lockdowns and the supply chain disruptions led to suppressed demand which, once it was released, brought about strong growth in GDP — 9.3% in 2021 and 6.5% in 2022. High consumption, which was in line with a global trend, led in turn to rising prices and the inflation that we are still grappling with.
The trend during the Covid pandemic and that of today have something in common: government aid. During the pandemic, it was a matter of compensation to businesses, the unpaid leave model, and the grant to every citizen, which raised liquidity in the economy.
Today, it's the aid to 140,000 displaced people, and the financing of the extensive drafting of reserve soldiers, which includes pay and also benefits and grants due to the reservists who for over a year have turned up time after time to defend the country. "The rapid growth in the total of liquid cash stems from the rapid growth of government transfers to many sectors, including drafted reservists, displaced people, and businesses. Monetary theory teaches that transfer payments can fuel inflation," says Katz.
The change comes on the spending side as well. A war lasting more than a year does not exactly encourage consumption. When bad news follows bad news, reservists and their families are called to the flag three times in a year, and large areas of the country are under massive fire daily, it's hard to maintain a routine of overseas trips and shopping. Spending on private consumption rose by 2% in the first half of 2024. If inflation and population increase are taken into account, this is actually a decline.
Will the money turn into inflation?
To understand the risk to the economy from the rise in the broad monetary aggregate, it is necessary to understand how easy it is for an ordinary consumer to use this money immediately. The most liquid asset is of course cash. According to the Bank of Israel, the Israeli public holds NIS 126 billion in cash, representing an 8% rise over last year. Next in the liquidity rankings is bank current accounts, in which the public holds NIS 500 billion, again 8% more than last year. Together, cash and current accounts amount to 30% of the broad aggregate. This is not a small proportion, but, for the sake of comparison, during the Covid pandemic (2020-2021) the proportion was 44-45%.
Most of the money that currently forms part of the broad monetary aggregate is in short-term savings and investments. The largest proportion — 38% — is in deposits for periods of up to a year. Together with money market funds, which account for 7%, and Bank of Israel short-term securities (makam), the proportion reaches 53%, more than NIS 780 billion. Some of this money can be withdrawn immediately, but that is not the consumer's default choice. This money is mostly kept to one side and earns a return.
In the pandemic period, the interest rate was practically zero, but, today, the Bank of Israel's rate is 4.5%, and has been for a while, and, as mentioned, not only is it not forecast to drop but it is liable to rise. Therefore, Katz explains, it's hard to estimate when, if at all, the monetary accumulation will translate into inflation. "If the public feels that there is a prospect of the war ending or dying down, we may see a rise in demand and perhaps also an interest rate cut, which at the moment is not on the horizon," he says. Leader Capital Markets assumes a lag of nine months in the impact of the rise of the broad monetary aggregate on inflation.
But will the growth in liquid capital necessarily turn into inflation in the future? Ofer Klein, head of the Economics and Research Department at Harel Insurance and Finance, says, "What could rapidly translate into a rise in prices is the cash in people's pockets and current accounts. Money in a one-year deposit cannot turn quickly into inflation. Such money is the first explanation for the rise, which is not all that worrying." He says that the rise in the amount of cash held makes sense when the rise in GDP and inflation are factored in. "If all prices have risen, it's necessary to hold more cash. That explains these rises," he says.
Klein is not alone. The link between cash held by the public and inflation is not inevitable. The European Central Bank, for example, pointed out a year ago that economists see it as becoming weaker, even if it has not completely disappeared. German economist Isabel Schnabel, who serves as a member of the Executive Board of the European Central Bank, has demonstrated that the correlation between the quantity of money and inflation rises as economic conditions become less stable. If the test is instability, it would appear that Israel is at high risk, since uncertainty has become one of the main characteristics of the Israeli economy in the past couple of years.
Schnabel believes that a high quantity of money fuels inflation and creates a situation in which price rises are more obstinate. If she is right, this could be one explanation for the fact that the high interest rate is struggling to rein in inflation.
Money market funds are the fastest-growing component of the broad monetary aggregate, having grown by over 54% from NIS 90 billion in August last year to almost NIS 140 billion this year. Money market funds are mutual funds that invest in low-risk short-term instruments such as Bank of Israel short-term securities, bonds, and deposits. These funds have gathered momentum in the past couple of years and have become an attractive alternative to bank deposits, both because the return on them is linked to the Bank of Israel's interest rate (4.5%, which is not a bad return on a non-equity investment), and because of the fact that these funds enjoy taxation benefits.
The tax rate on the interest on a shekel deposit is 15%. If, for example, you put NIS 10,000 on deposit at a bank and it earned 4% interest in a year, you would pay NIS 60 tax. With a money market fund, although you will be charged 25% tax on your capital gains, the tax is only on the real gain, after discounting the rate of inflation during the period. So if on an investment of NIS 10,000 you made a 4% gain in a year, but annual inflation was 3%, you pay 25% tax only on the remaining 1%, that is NIS 25.
Klein says that the growth of the money market funds highlights the unlikelihood of a higher monetary aggregate leading to inflation since they currently benefit from high returns and low risk. "As long as interest rates remain high, people will keep their money there."
The big question, though, is how the day after high interest rates, or the beginning of a decline in interest rates, will look, sometime in 2025, according to the Bank of Israel's most recent forecast. How long will it take for lower interest rates to translate into consumption? Klein points out that the Bank of Israel's monetary policy is partly designed to prevent a sharp switch from saving to consumption. "The Bank of Israel carries out interest rate cuts gradually since it does not wish to create a wave of inflation when savings are released and go straight to consumption." The central bank's goal, Klein stresses, is to maintain price stability, and it does so in a variety of ways and with fine adjustments to avoid an inflationary spiral.