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Surprise Israel rate cut was about strong shekel, weaker economy

JERUSALEM, Oct 30 (Reuters) - Israel's surprise rate cut appears to have come from a confluence of a rising shekel meeting a weakening economy.

The central bank on Monday lowered its benchmark interest rate to 2 percent from 2.25 percent. All 12 economists polled by Reuters beforehand had expected unchanged rates for a fourth straight month.

The cut was particularly surprising given that the Bank of Israel had expressed concern over rising housing prices, according to the minutes of its September 24 rates decision.

Indeed, the Bank of Israel's own economists had forecast no rate changes through 2013. Most attention was being paid on the strength of the economy rather than of the currency.

But the shekel has been appreciating. It reached 3.81 per dollar by mid-October from a level of 4.02 at the start of September. It has since moved back to a rate of 3.90 but the Bank of Israel is opposed to a strong currency since it harms Israeli exports.

Exports account for more than 40 percent of Israel's economic activity.

``The Bank of Israel has a strong preference to avoid currency appreciation,'' said Citi's David Lubin. ``It is possible that the Bank of Israel would like its rate to be as low as possible to discourage foreigners from developing an appetite for the shekel.''

When the shekel has strengthened in the past few years, the central bank has countered with heavy dollar purchases that totalled some $50 billion.

One of the main reasons the central bank had stayed on hold since cutting rates last in June is the resiliency of the economy. The bank last month raised its 2012 economic growth forecast to 3.3 percent from 3.1 percent.

But it lowered its 2013 estimate to 3 percent from 3.4 percent. And in the past month, various consumer and business surveys signalled economic weakness ahead, while the purchasing managers' index has held below the 40 point level for two months, indicating contraction in the manufacturing sector.

The central bank also stressed that the absence of a budget due to early elections in January would harm the economy early next year since government spending will be restrained.

``This move increases the likelihood of fiscal consolidation and tighter fiscal policy,'' said Murat Ulgen, HSBC's chief economist for central and eastern Europe. ``In the first two to three months of 2013, until the 2013 budget is approved, government spending will be severely restrictive. This allows the Bank of Israel to run a more expansionary monetary policy.''

At the same time, the central bank is not worried about inflation, with the annual inflation rate at 2.1 percent in September - within an official 1-3 percent target.

It also addressed the issue of rising housing prices by limiting mortgages -- a move that most analysts doubt will work.

``The Bank of Israel have decided that the risks to the inflation outlook are sufficiently benign that they can afford to buy a little extra insurance against further downside risks to growth,'' said Deutsche Bank Chief Economist Robert Burgess.

But he was not expecting more.

``Monetary policy is now very accommodative and .. We think the Bank of Israel will revert to a holding pattern,'' he said.