With inflation back in the annual target range of 1%-3%, the markets and mortgage takers had been expecting to hear that the interest rate was being cut from 4.5% to 4.25% just ahead of the Passover holiday. But the Bank of Israel Monetary Committee headed by Prof. Amir Yaron had other ideas.
In an interview with "Globes," Prof. Yaron explains the decision, protests against the cabinet's failure to adopt the Bank of Israel's recommendations on the state budget, including incentives for haredi employment, and sets out his belief that despite everything Israel can avoid another rating cut.
On last week's decision to keep the rate unchanged Yaron says, "We are not in a bubble. We always have our feet on the ground. We understand that raising the interest rate is painful, but we have a holistic view. On the one hand, we use our entire data set. This includes the credit data database and data from the supervisor of banks.
"We look at where we stand and understand that there are people that are hurting. But, we also understand that if we don't fight off inflation there will be a much bigger problem here, which will especially hurt these socioeconomic groups."
Criticism of the Bank of Israel's decision is not only from households and businesses. Even in the capital market, there are those who find fault with the decision, claiming the bank had presented guidelines in which the interest rate would decrease with every other decision. The argument is that the bank, which holds foreign exchange reserves of more than $200 billion, could have used them to stabilize the market rather than through the interest rate.
Don't you think the bank's credibility with the markets has been damaged?
"Since the outbreak of the war, we have pursued a policy that includes stabilizing the markets while normalizing inflation and bringing it to its target range. In the past I have warned that if the security situation escalates, we would emphasize stability rather than normalization."
Yaron explains that the bank has again stressed this balance. "On the contrary, we have increased our credibility and stressed the choice of the stability of the markets. We need to act with caution in light of the price picture, which is not clear at all, and the markets understand this." The Governor repeated the bank's forecast, which sees an interest rate of 3.75% at the end of 2024, and said, "If we see the security situation moderate and the inflationary conditions stabilize, we will act accordingly."
On the situation with Iran, Yaron says, "I am not a defense expert, but the events have raised the geopolitical uncertainty. We have seen a rise in bond returns, in the CDS (risk premium on government bonds) and we have also seen it in the shekel exchange rate. Therefore we took the decision that we did. Beyond the geopolitical situation, it is important to remind people that inflation matters enter our considerations. For example, we have seen the price of fuel jump higher."
"Governors like to talk in 'understatement'"
The Governor is a man of numbers. Only recently, during the war, Yaron was appointed to a second five-year term. Before the war it was believed that the government would prefer to see another person as head of Israel's central bank and that Yaron might return to his academic position at the University of Pennsylvania's Wharton School. In his first term, seemingly saw it all - Covid, military operations, five election campaigns and the judicial reform upheaval. It is doubtful if he had previously experienced so many complex events during his lifetime.
The Bank of Israel took a battering from government coalition members before the war and since. Do you think the government and Knesset respect the institution of the bank and appreciate its work?
"I think that the independence of a central bank is very important. The markets and the international organizations are constantly looking at this as a key parameter. We are always in dialogue with the government and legislators, and really try to bring our professional opinion on every issue. But at the end of the day, I think they also understand that the independence of the Bank of Israel and its professionalism help the economy. If bodies in the markets were to think that we do not work independently or professionally, and sometimes begin to be influenced, this could lead to damage to the Israeli economy, so we are careful on the issue."
In the Bank of Israel's reports, you have commented that the expansionary fiscal policy of the government makes it difficult to lower the interest rate. Shouldn't you raise a red flag and take more drastic measures than you have done so far?
"I want to make a distinction between the budget frameworks and its components. The original budget that the government passed, in May of last year, was a correct budget in terms of the frameworks. There were voices that wanted a bigger deficit, but we managed to keep the framework with a deficit of around 1%. But you have to enter the details of the budget, and this is where the issues that we always put aside come up. Israel has a dynamic, durable economy, with high-tech that can compete anywhere in the world. But we also have, in the longer term view, challenges of education. We see huge gaps in the field. This is something that really hurts me as someone who comes from the world of education. It just hurts me personally to see the inequality in the periphery, in the Arab sector and of course in the ultra-orthodox world. Education is the biggest game changer on a personal level."
The Governor points out that some of the incentives for working have become even more negative, especially regarding productivity, and he does not hide his disappointment with the budgetary handling of the issue. "Our two 'ticket items' at the Bank of Israel in terms of budget, which are most significant for the growth of the economy in the future, are firstly education and imparting skills and human capital and for sure when we are entering the world of AI. "Secondly, the issue of transport infrastructure, which also affects the housing market. When you look at the components in the budget, there was certainly less than desired, and some of them even had negative incentives," he says, perhaps referring to the coalition agreements with the ultra-orthodox parties to finance educational institutions that avoid core studies and subsidizing yeshiva students through state allowances. Yaron's criticism is couched in hints and gentle terms, but as he admits, "Governors sometimes like to speak in understatement."
Promises to the ratings agencies and Gafni's 'hole'
Together with the revised state budget approved last month, a multi-year package of cuts and adjustments was supposed to be passed, designed to offset the expected permanent increase in defense spending in the coming years. This fiscal package was sold by the Governor and the Ministry of Finance to foreign investors and rating agencies as a guarantee of responsible government conduct. However, at the last minute, Knesset Finance Committee chairman Moshe Gafni, decided to freeze a third of the cuts, creating a NIS 6.6 billion hole. After Fitch left Israel's rating unchanged although cutting the outlook from stable to negative, next month it will be S&P's turn to decide whether to cut Israel's rating.
The coalition broke your word to the ratings agencies and cut Israel's main argument for its defense. How will S&P respond?
"I say that the government passed in the 2024 budget what it needs to pass. It is true, some of the adjustments will express themselves later and some of them even came from the Economic Arrangements Law. But the rating agencies see that we can adjust according to the needs of the moment and comply with the necessary adjustments. I still think that the framework is a relatively good framework, and has a declining debt horizon and can be viewed positively. In the end, everyone understands that we are in an environment of great uncertainty."
The Governor declined to comment on whether he had already spoken with S&P prior to the upcoming rating announcement, but said: "We emphasize the strengths of the Israeli economy in these talks, and must do so in a credible manner."
On the positive side, the Governor points out that the strong recovery of the economy can be seen, and that history reveals that Israel usually returns to high levels of growth after crises. "State revenues have increased recently, the employment market is strong, and private consumption is returning to its level," says Yaron. He qualifies that the uncertainty can change everything due to the difficult geopolitical events. The big question is how long they will last and what their impact will be.
Concern about the future defense budget
The rating agencies and investors are concerned about the deterioration of Israel's debt-to-GDP ratio due to future defense spending needs for many years to come. Prime Minister Benjamin Netanyahu announced the establishment of a special committee to examine the defense budget, which is currently being delayed, and it seems that even if it is established, it will have a decisive majority of representatives from the defense establishment. Yaron calls for the establishment of the committee and says: "It is clear to all of us that it is impossible to know from a brief glance where we want to be in military strategy in 5-7 years. It is important to examine what is needed, and what may no longer be needed. Because of the scope of the budget, this is already a macroeconomic issue."
However, Yaron fears a scenario in which the committee's conclusions will allow increasing the defense budget beyond the additional NIS 100 billion over seven years, which was agreed between the ministries of finance and defense. "If the same committee that will be established points to much greater needs, it changes the basic assumptions," he says. The same basic assumptions, which were put into the budget and the economic forecasts, also include that the war will take place mainly in the south, and that US aid is on the way. "Any movement away from these will require adjustments," he adds.
How much does the construction market and lack of building workers concern you?
"This is an important industry that makes up a large part of the GDP. We have seen in the past that it took a long time to return workers to the construction market, so with all due respect and the desire to bring in foreign workers, the goal of bringing in 100,000 foreign workers will take time and there is a financial cost to that."
The Governor explains that the market in Israel is very sensitive to supply. In his opinion, the solution, at least in the short term, is with Palestinian workers who have been banned from entering Israel since the outbreak of the war. In his opinion, if the security forces can allow the entry of Palestinian workers, it would benefit our economy.
Beyond the issue of Palestinian workers, Yaron indicates additional steps that can be taken. He says,, "We need to diversify the mix of foreign workers. In addition, the industry can make a leap in the technology introduced in the field in order to become more efficient." Yaron reiterates that the construction industry is extremely important and the lack of workers is expected to affect growth for at least the next two years.
"Tax burden will become heavier and households will be hit"
The IDF Draft Law is a political issue but the law that will ultimately be adopted will have a dramatic economic and social significance. The Governor is relatively cautious when talking about the matter but his message is clear.
"The first aspect is the employment market. We mentioned this a lot and there were haredi elements who criticized this analysis. I see great importance for the haredi sector in entering the job market, and doing so with adequate skills and salaries, and for this we need core studies," says Yaron and he warns of a scenario in which this will not happen. "By 2060, the haredi sector will make up about a quarter of the population in Israel, and if they do not enter the job market, the potential damage to the economy will reach 6% of GDP. This will put us at a level similar to Poland. Beyond that, the tax burden will be increased by 16%."
The second aspect is the needs of the army. He says, "The Ministry of Defense indicates that we need more manpower. The army needs more reserve hours and ultimately these reserves are working people with high productivity. At this point we are also hurting households. From an economic point of view, this is a very large economic burden."
The banks are reporting record profits and the Governor is under fire
The biggest beneficiaries of high interest rates are the banks, which broke records last year. The combined profit of the five largest banks in 2023 was almost NIS 26 billion. On the eve of the war, the Bank of Israel came under fire for claims it was allowing banks to do this, at the expense of the public. Minister of Finance Bezalel Smotrich even threatened to pass legislation that would subject them to excess profits tax. Emergency meetings were held at the Bank of Israel and pressure was put on the bank chiefs to hand over more of the profits to the public. The final result was one-off benefits for those in the black in their current accounts, and a one-time payment of NIS 2.6 billion to the state coffers.
Couldn't you have done more on the matter of the banks?
"We are on a journey to promote and improve the financial system and competition in particular. This journey is not over. Many moves have been made. New banks have been established, a one-click transfer reform has been launched, and more."
Yaron mentions that the period of high interest rates is unusual, certainly after a decade of zero interest rates. "The economic environment resulted in large profits. It is likely that there will be a moderation in bank profits in the future. We also hope that the steps we have taken will lead to more competition. We are trying to bring more players into the market."
Banks and the banking system is a unique branch, says Yaron, "Stability serves the economy. It happened with Covid and it's happening now. The banks came and gave an outline of payment deferrals, which is important in a country where there are many unusual events. It is an important safety factor."
Responding to the criticism, Yaron adds, "It is important not to underestimate the importance of bank stability, we saw what happened last year in the US banking crisis. Here we see a faster response to the needs of the economy by the banks. The work continues, but we don't want to do it while interfering with the market mechanism. If we do that, we will be perceived by the world as a completely different country."
Published by Globes, Israel business news - en.globes.co.il - on April 14, 2024.
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