(Adds OECD, Finance Ministry comments)
JERUSALEM, March 11 (Reuters) - Israel's economy faces a risk of overheating should the Bank of Israel wait too long to start raising interest rates, the Organisation for Economic Co-operation and Development (OECD) warned.
In its biennial report issued on Sunday, the OECD said Israel's economy continued to register "remarkable macroeconomic and fiscal performance" and that it expected a major payoff to come from planned investments in offshore natural gas fields.
But while it was upbeat on the near term economic prospects, it was sober on the longer term, saying more Arabs and Ultra-Orthodox Jews - Israel's poorest communities - needed to join the workforce. Together they are expected to be half of Israel's population by 2060.
"Because of the demographic trends and labor participation rate of the Ultra-Orthodox and Arabs ... sooner or later it will have a macro economic consequence," OECD economist Alvario Pereira told a news conference in Jerusalem.
Finance Ministry chief economist Yoel Naveh said the state was working on it, but it would take time since Ultra-Orthodox Jews and Arabs were not overly eager to join the labor force.
The OECD praised the central bank for maintaining a very accommodative policy, in which the benchmark interest rate has stayed at 0.1 percent for three years, while buying foreign currency from time to time to prevent an excessive appreciation of the shekel. But it also issued a warning.
Low inflation does not seem related to weak demand, and tightening too late would increase the risks of overheating and rising wage pressures, which, with increased competition, would harm business profitability and investment, it said.
"Sooner or later the Bank of Israel has to be prepared to increase rates when inflation starts nearing the target," Pereira said.
Israel's annual inflation rate was at 0.1 percent in January but the Bank of Israel expects the rate to move back into the government's 1-3 percent target by year-end, boosted by rising wages. Similarly, the OECD projects a 1 percent rate in 2018, rising to 1.7 percent in 2019.
As such, Bank of Israel economists expect a 15 basis point rate increase to 0.25 percent by the end of 2018, although most private economists believe inflation will move back to its target only in 2019, with the first rate hike also next year.
Policymakers have stressed that rate hikes would start only when inflation is entrenched in the target range.
Israel's economy grew 3.4 percent in 2017, helped by strong population growth and a robust high-tech sector, and the OECD forecasts 3.5 percent growth this year and 3.4 percent in 2019, in line with central bank estimates.
It noted that production of the Leviathan gas field late in 2019 will add 0.3 percentage points to economic output while a sovereign wealth fund being set up from excess profits from gas sales could represent 10 percent of gross domestic product by 2040, the OECD said.
The OECD largely praised the state's fiscal policy and a declining public debt burden but recommended more spending on education and transportation infrastructure as well as improving tax collection.
Pereira noted that Israel's civilian spending was the lowest of OECD countries.
It said Israel should loosen a "rigid" policy on real estate supply to lower home costs since "risks of a house-price correction are still high." (Reporting by Steven Scheer Editing by Mark Potter)