Here is a not an especially fanciful scenario. The governor of the central bank comes into the meeting room, where he is due to make a pivotal decision on monetary policy, determined to initiate a new direction and even raise interest rates to fight rising inflation. However, the latest data about the foreign currency exchange rates, which has been put on his table several hours earlier, indicates a large sell off of foreign currency and an appreciation of the local currency, restoring it to its previous value and endangering exports.
What will the governor do in light of this data? If his name is Stanley Fischer and he is the Governor of the Bank of Israel, then his troubles are not simple. The dollar has weakened in Israel for the same reasons that it has weakened around the world. The US currency is considered a refuge or a shelter for nervous people burned by the falling stock market. If the market rises, then confidence returns, and the dollar weakens. This is what is happening around the world. On the local scene similar forces are at work, alongside the belief that domestic interest rates are about to rise next month. The result is the strengthening of the shekel to levels of around NIS 3.80/$ today.
In fact Fischer’s big problem is his “exit strategy.” The intention is to retreat, in a more or less orderly fashion, from the central bank’s three main policy measures in recent months: buying dollars; buying government bonds; and low interest rates. The intention and the planning were clear: The recession would ensure that inflation is moderated and therefore it becomes possible to use monetary instruments to assist exports and support credit to the business sector by lowering medium and long term yields.
The problem is that inflation did not fall, among other things because of the prices of energy and housing. Now Fischer must decide on how to get out of the web. Low interest makes institutions buy shares and makes the public buy homes. It also feeds inflation, and as far as can be judged, the response to the problem will be to raise interest rates, before Fischer feels that the inflationary flight will take off and will be unstoppable.
What will happen to the shekel? On the face of it, it is reasonable to assume that it will strengthen and that might be the price that Fischer will be forced to pay to regain monetary control after several months in which the amount of money has grown at an annual rate of 50%-60%.
Because there can be no half policy changes, the decision to raise interest rates, or even to hint that in another month such a measure will be possible, will require retreating from other areas of the current policy. In principle it is possible to carry on buying dollars and absorb surplus shekels by selling treasury bills. But even to this measure there must be an end. The policy of buying bonds injects liquidity but is also not consistent with the decision to adopt a policy of reduction. In the end the change will come, right down the line and on every front.
Fischer’s problem, like that of another central bank governor in the world, is that he is forced to make a change of policy direction when he is partly blind. True, some of the statistical “sensors” point towards recovery but nobody knows if this is an “Indian summer” after which the recession will return. Raising interest rates in this situation could be the remedy for the wrong illness. If so it will be accompanied by a rise in medium and long term bond yields and the damage could be stronger.
Published by Globes [online], Israel business news - www.globes-online.com - on July 27, 2009
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