There are two perspectives to the Bank of Israel's decision to cut the interest rate by 25 basis points and to tighten mortgage loans. The first perspective is on the monetary policy itself, and the second is derived from the Bank of Israel's as Governor Stanley Fischer sees it.
From the perspective of monetary policy, the unexpected interest rate cut can be interpreted as expressing the central bank and Fischer's fears of further slowing of the Israeli economy. The Bank of Israel forecasts 3% growth in 2013, which fits in with developments of the past few months. But 3% growth is the dividing line between growth and slowdown, and growth of less than 2% can be considered a recession. Under these conditions, the Bank of Israel should ask itself whether there are factors on the horizon, which might push the growth rate below the yellow line of slowdown, or even below the red line of recession.
A darkening cloud
Fischer's conduct indicates that he is worried about these factors. The worsening crisis in Europe is like a storm cloud over the global economy, and the US economy is unlikely to grow rapidly in the near term, with or without Hurricane Sandy. Israel has no effective government to set economic policy, at least for the next six months. Fischer sees this too when he calculates the risks through the spring of 2013.
The price that monetary policy should pay for Fischer's decision may be high. The real interest rate is becoming negligible, at best, or negative, if inflation falls below 2% a year. Here too, attention should be paid to what the Bank of Israel's decision says about inflation expectations, especially what Fischer expects. We can assume the he predicts low inflation over the coming months, and that there is no serious restraint on price stability. It is highly doubtful if Fischer would have cut the interest rate if he thought that it would cause a prolonged negative real interest rate.
In any event, between the risk of a slowdown, or even a recession, and the risk of a negative interest rate, Fischer opted to cope with the former.
What remains open are home prices, and fears of a new real estate bubble, which would undermine the banks' financial stability. Fischer chose to deal with this risk directly, as a specific problem, using non-monetary tools. This deviation from the norms of a central banker as set down in the schoolbooks written before the economic crisis will generate plenty of criticism against Fischer.
The deciding argument
This brings us to the second perspective when looking at Fischer's decision, which is the role of the central bank. Once, before the great economic crisis, countless articles and books were written which asserted that a central bank's only job was to ensure price stability, and to act on the basis of strict predetermined rules, and without considering anything other than inflation. This became an article of faith among some economists.
Israel is lucky that Fischer understood four years ago that that argument is invalid. A central bank can and should use its discretion and take a full range of factors into account, including financial stability and economic growth. When the government is paralyzed, it is the job of the central banker to be expansionist. When times are more clement, the central bank will deal with price stability.
Fischer does not act according to the "clear rules approach". He is risking a negative interest rate, preferring to limit the risk of recession. The argument about rules or discretion has been decided by Stanley Fischer.
Published by Globes [online], Israel business news - www.globes-online.com - on October 30, 2012
© Copyright of Globes Publisher Itonut (1983) Ltd. 2012