1. The slowdown: The decision by Governor of the Bank of Israel Stanley Fischer to cut the interest rate by 25 basis points indicates his growing concern about a slowdown in the economy, and raises the question what further steps he might take if there is no change in the growth trend.
There are two important lines for understanding yesterday's decision by the governor, and the decisions that will be made in the coming months. The first line is 3% growth. Any growth rate below this line represents a slowdown in the Israeli economy. The second line is a growth rate of 2%. Anything below that line represents recession, and faster growing unemployment.
Fischer acted when the first line, 3%, was crossed in a downward direction. According to the Bank of Israel's forecast, the Israeli economy will expand at a rate of 2.8% next year, discounting the effect of possible swapping of expensive energy from foreign sources by comparatively cheap local natural gas. When the effect of the gas on the national accounts is brought into play, the result is a growth forecast of 3.8%. This rate is however the less relevant one in the governor's eyes at present.
2. Inflation and home prices: The inflation figures for the past few months have given Fischer a large degree of freedom. The annual inflation rate is not rising above 1.5%, enabling Fischer to deal with real developments in the economy without having to keep an anxious eye on what is happening to prices. Home prices too have at last settled on a low-rise curve.
On housing demand too, the governor can feel that he has fairly extensive room for maneuver. Measures by the Supervisor of Banks in the past few months have been directed at limiting the ability of the banks to translate cheaper money into a faster flow of mortgages. The maximum permitted loan-to-value ratio has been reduced, and the variable rate component has been limited for new mortgages. If there is still a prices problem, it lies on the supply side, not in demand.
3. The capital market: To judge from the reception given to the interest rate reduction in the first few hours of trading today, the market has been more impressed by the message about a slowdown in activity than by the expansion of liquidity and the lower cost of money. Basically, the market will have to decide in the coming days whether we can expect to cross the 3% line again, or whether we will come closer to the 2% recession line.
This matter, of developments over the next few months, is much less to do with Fischer, and much more to do with what the new government that will arise after the elections does. Until the government is formed and a new budget is passed, fiscal policy will be paralyzed, and it will be possible to respond to any external event that threatens growth only via the interest rate.
"External event" means, first and foremost, the way in which the confrontation ends between US President Barack Obama and the Republican-controlled House of Representatives. If the US jumps off the fiscal cliff, the local response will be an even lower interest rate, but it is doubtful if that is what will stimulate the local economy.
4. Interest rates, the foreign exchange market, and the global economy: What has been said about the capital market applies to the foreign exchange market as well. The value of the US dollar in the coming weeks will be determined by the way in which the negotiations between Obama and the Republicans in the US end.
This is on the assumption that there is no skeleton currently hidden in some European cupboard. If there is no agreement, world financial markets will be subject to very high volatility, and this will be reflected on the foreign exchange market and on the markets as a whole. Under a scenario like this, Israeli interest rates will be a tiny drop in a very big storm.
But even if the two sides in the stand-off in the US reach a compromise and an agreement, the governor's move will carry small weight in determining the shekel exchange rate. If there is an agreement, the dollar ought to appreciate on world markets. The local currency market will feel the combined effect of a lower interest rate and a stronger US dollar. Fischer would presumably buy such a scenario without a second's hesitation. For the time being, he remains in the position of a concerned citizen.
Published by Globes [online], Israel business news - www.globes-online.com - on December 25, 2012
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