Bank of Israel Governor Karnit Flug in March 2014.
Bank of Israel Governor Karnit Flug has not been seeing eye-to-eye with Finance Minister Yair Lapid of late. Photo by Emil Salman
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The Bank of Israel cut its main interest rate to an all-time low on Monday, seeking to revive economic growth and boost exports in an environment of very low inflation.

The central bank, which cut its September rate by a quarter point to 0.25%, said it was striving to “return the inflation rate to within the price stability target of 1%-3% a year over the next 12 months, and to support growth while maintaining financial stability.”

In a statement, it noted that in the past 12 months inflation had dipped to a paltry 0.3%.

The shekel, meanwhile, had slipped 1.7% this month, so a further decline in rates and a weakening of the currency would support an export recovery as Israeli goods become more competitive abroad.

Still, the outlook for economic growth is mixed, as “the global picture continues to indicate limited recovery, with renewed growth in the U.S. and moderation in Europe and Japan.”

The decision sent the shekel plummeting against the dollar. While the representative rate was set before the announcement, at 3.543 shekels to the dollar, the exchange rate shot up to 3.572 shekels to the dollar, a jump of three agorot in mere minutes. The dollar has gained 3.9% against the shekel since Operation Protective Edge began in early July.

The announcement also sent the Tel Aviv Stock Exchange jumping in the final hour of trade. The TA-25 index gained 0.85% to close at 1,383.73 points for the day.

In July the Bank of Israel, led by Governor Karnit Flug, cut its main interest rate by a quarter point to 0.5%, citing in part the uncertainty created by the fighting in the Gaza Strip, now in its seventh week. Earlier last month, Bank Leumi trimmed its economic growth forecast for 2014 to 2.7% from 2.9%.

According to the Central Bureau of Statistics, the economy is already stagnating in terms of gross domestic product per capita.

Aside from the economic implications, the decision is an assertion of leadership by Flug, who succeeded Stanley Fischer as governor last year. Flug was a last-choice candidate for Prime Minister Benjamin Netanyahu. Fischer also made some dramatic decisions as governor, including regarding Israel’s interest rate.

On Thursday, Israel’s banks will cut the interest rates they charge customers in response to the bank’s move, including interest on overdrafts. In many cases, banks will pass on the full 0.25% rate cut.

The decision to cut interest rates to an all-time low surprised the capital market, including Israel’s investment banks.

“Cutting interest rates is a declaration by the Bank of Israel that it intends to support economic growth, given the Gaza operation and its implications for the economy,” said Ilan Artzi, chief investments officer at Halman-Aldubi Group. The central bank is afraid that third-quarter economic growth will be negative, he added, noting that the central bank hopes its move will also depress the shekel’s value against the dollar.

“The main problem that the central bank faces now is that it’s exhausted its use of interest rates, and to encourage growth in the future it will need to use other monetary tools, such as buying bonds,” he said.

Elad Solomon, an analyst at the Utrade Investment House, expressed surprise over the monetary policy committee’s decision. “The decision is controversial and surprised the market,” he said. “It will add additional fuel to raging property prices. It’s also created an economic distortion in terms of compensation [to investors] given the risk level in the Israeli economy. I believe the bank governor is interested in making credit cheaper, so we’re likely to see more corporate bond issues” as companies look to raise cheap money, he said.

Shmuel Ben-Arieh, head of research at the Pioneer Group, agreed that the central bank has exhausted its use of interest rates in its last two decisions. “Apparently the central bank was concerned by inflation rates, which are currently under the price stability target range for 2014,” he said. Therefore, the bank has made money dirt cheap so that citizens simply stop saving and instead go out and spend their money.

“It appears that what has been until now will continue to be the case. Most of the cheap money will go into the real estate market. If no limits are imposed, the money will keep going into the mortgage market and inflate the real estate bubble even further, apparently boosting demand as well,” he said.