Next week when Governor of the Bank of Israel Prof. Stanley Fischer travels to Washington D.C. for the annual meeting of the International Monetary Fund, he will be envied by many of the other central bank chiefs. For the vast majority of his counterparts those halcyon days when they were talking about the threat of inflation and tough monetary policies have long gone.
In contrast, Fischer can mingle among the other central bank heads with an imaginary tag around his neck saying "2% interest rate and still rising."
This description characterizes the situation Fischer finds himself in and the state of the Israeli economy, which in contrast to other developed economies is not coping with small growth and a shaky financial system.
So from that standpoint, Israel's monetary policy can and must be different from other world economies. If the conditions in the Israeli economy are better than reasonable then interest rates cannot be zero or negative, and must rise higher.
In its announcement yesterday that the interest rate was being raised by 25 basis points, the Bank of Israel said, "the decision to raise the interest rate for October to 2% is part of a gradual return to 'normal' interest rates to consolidate inflation within its target range and support continued growth while maintaining financial stability."
The question, of course, is what is 'normal' interest rates? It is reasonable to assume that if inflation is expected to be about 2-2.5% this year then real interest is zero or even negative, and that cannot be considered 'normal,' at a time when output is rising, unemployment is falling, and nominal salaries are also increasing. In other words, the Bank of Israel raised interest rates because it planned to do so in advance, and will continue to raise the rate to reasonable 'real' levels. Therefore, there is no need to be surprised if at the current pace of growth interest rates will be raised to 2.75% or even 3% over the coming year.
It's because of apartment prices
It is important to stress this point in light of the commentators who see apartment prices as the reason behind Fischer's decision. It is true that apartment prices are the "principle suspect" in the opinion of analysts and commentators, which brought about yesterday's hike. There is no doubt that that the rapid rise in apartment prices is bothering the Bank of Israel, mainly because of its influence on inflation. But even if apartment prices were to stabilize, interest rates in Israel would continue to rise while inflation was 2% or more, until the Bank of Israel decides that we have returned to 'normal conditions.'
How long will be required for the Bank of Israel to return to that level? That too was detailed by the central bank's announcement yesterday. "The rise in the interest rate is not fixed but depends on the inflationary environment, growth in the Israeli and world economy, monetary policy of the main central banks and taking into account developments in the foreign currency exchange rate of the shekel."
Steinitz is finding it difficult to understand
Translated into simple English, the Bank of Israel admits that the timing of raising interest rates in the coming year will depend on factors like the shekel exchange rate, but over time, interest rates will rise. The Bank of Israel can operate in this way because the private sector well understands the rules of the game and the limits that the central bank set out for trading in foreign currency back in August 2009.
Every movement in the shekel exchange rate reflecting basic macroeconomic factors or changes in the exchange rate of the dollar against other currencies will not result in any action by the Bank of Israel. However, any movement reflecting speculation will bring about the intervention of the Bank of Israel and result in losses for anyone gambling on a sharp appreciation. This simple rule is understood by foreign and local investors although Minister of Finance Yuval Steinitz still finds it difficult to comprehend the rules of the game determined by the Bank of Israel more than a year ago.
Meanwhile, back at the IMF conference, Fischer will be a focus of interest on the topic of foreign currency exchange policies. The world system of foreign exchange will be the topic of a major debate by central bank chiefs and minister of finance with a growing feeling among many that there is room for intervention to prevent the strengthening of currencies especially in successful countries who are seeing their private sectors hit.
The frustration and bitterness of those countries has been growing in recent days because of the weakening of the dollar and the actions of investors in hedge funds. These countries, mainly in emerging markets with financial stability feel they are suffering from the appreciation of their currency and devaluation would benefit local industry. On this matter Fischer can recount the "Israel experience" and how his central bank coped with this difficulty. If the Israeli Minister of Finance is invited to one of these discussions, perhaps he will begin to understand how the Bank of Israel operates.
Published by Globes, Israel business news - www.globes-online.com - on September 28, 2010
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