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Fischer's 'Ratchet Effect'

I was way off the mark. Moments before the governor's announcement, I spoke with a friend who was very interested to see what the governor would do. I told him there was no suspense involved, and I predicted Stanley Fischer would stay his conservative course and reduce the interest rate by only 0.25 percent. His comments hinted as much.

But this time Fischer surprised us. He reduced the interest rate by 0.5 percent for January - to 4.5 percent - placing the Bank of Israel's rate substantially lower than that of the U.S. Federal Reserve, which stands at 5.25 percent. Once, not long ago, the very idea that our interest rates could be lower than American rates was blasphemy.

In the U.S., they said: Could the risk in the Israeli economy possibly be lower than in the American economy? Any attempts to argue that the two economies are completely different, that some small countries dare maintain a lower rate than that of the U.S., were useless.

In this respect, Fischer has undergone a dramatic change. And there is another reason for the sharp decrease: the incessant attacks by analysts and economists over the past months, who maintained we would miss our inflation target because Fischer was retaining an excessively high interest rate.

And it's true; Fischer missed it. This year's inflation rate will be near 0 percent, below the target of 1 to 3 percent. But why is this so very important?

It is important in terms of market activity and employment, and this is what the "ratchet effect" refers to.

It's like a cog-wheel that can move in only one direction. This is the case of wages, which only rarely decrease. It is, after all, clear that when the inflation rate is zero, not all prices remain unchanged. Some decrease and some increase.

In sectors where prices have dropped, employers would prefer to reduce wages to avoid losing money, but they cannot, due to the ratchet effect. As a result, they are forced to shrink their activity, lay off employees and reduce their yield. Therefore, zero inflation is bad, and Fischer wants to avoid it.

He already failed in 2006, but he wants to avoid repeating the mistake in 2007. He knows that the balance of payments is in excellent shape, that dollars continue to flow into the country, and that the exchange rate may well continue to drop, taking prices with it.

This is what he wants to avoid. Because missing the target once is bearable, but causing damage for two consecutive years is just too much.