The Bank of Israel is considering a substantial change in its method of intervention in the forex market. Israel's central bank believes that the change will enhance the effectiveness of its measures on the interest rate and the shekel exchange rate. The significance of the change is that its foreign currency purchases will increase the number of shekels in the economy and lower the market interest rate. On the other hand, it is liable to increase inflationary pressure. It is therefore possible that the Bank of Israel will utilize this tool in order to move inflation more quickly into the target range, after inflation moved below the range last month.
The Bank of Israel's foreign currency purchases in recent years have been what is called "sterile" in professional language. The Bank of Israel paid for the dollars it bought in shekels, but at the same time "absorbed" the same number of shekels by issuing short-term loans (STLs) or deposits of the banks at the Bank of Israel.
The idea being considered is to stop "absorbing" the shekels when foreign currency is purchased, which will increase the number of shekels in the market. Since more shekels will compete for the same number of STLs, prices will rise, meaning that the interest rate offered for the STLs, which are issued at the Bank of Israel interest rate, will fall.
The recent interest rate hike from 0.1% to 0.25% made the option of "non-sterile" intervention more concrete, because the effective interest rate now has more room to go down. "Non-sterile" intervention is therefore a type of quantitative easing that lowers the interest rate in the market, but is also liable to generate inflationary pressure, because it amounts to printing money. The inflation rate will therefore be an important consideration in the final decision about whether to switch from "sterile" to "non-sterile" intervention in the foreign currency market.
Since Prof. Amit Yaron began his term as Governor, the Bank of Israel has purchased only $65 million as part of its intervention in the foreign currency market. Even before he took office, the Bank of Israel almost completely halted its planned purchases of foreign currency under the natural gas plan. Yaron surprised many in the market by preferring to refrain from intervention in foreign currency trading after the shekel-dollar exchange rate fell below NIS 3.50/$ two weeks ago, thereby breaking through a psychological barrier. Yaron confined himself to a "verbal intervention" - an announcement on his behalf that no interest rate hike is likely in the near future.
At the same time, when Yaron mentioned that he had other tools at his disposal besides the interest rate, he was referring to a real possibility of intervening in the market if the central bank believes that the shekel is deviating from the exchange rate limits to a greater extent than can be economically justified. Another important factor in the Bank of Israel's considerations is inflation - if speculative and short-term transactions cause a shekel appreciation, causing a deviation from the inflation target, the central bank will be more inclined to intervene.
The Bank of Israel said in response, "As we have stated before, without mentioning details, the basket of tools at the Monetary Committee's disposal is varied."
Published by Globes, Israel business news - en.globes.co.il - on August 14, 2019
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