Hard look / The big switch at the Bank of Israel

The Bank of Israel has adapted its mandate to the times. It aims to tame inflation, as always, and to protect exporters' profits as well.

The central bank's surprise ambush of the foreign currency market has at least one enthusiastic supporter: Shraga Brosh, president of the Manufacturers Association - the very organization that declared all-out war on the Bank of Israel in the latter part of the last decade and again midway in the current one, when the central bank adamantly maintained that its sole function was to meet the government-set inflation targets.

The central bank is showing itself to be an aggravating rather than a stabilizing influence on the economy, implementing expansionary and disproportional monetary policy. It has cut interest rates dramatically and flooded the money market with liquidity by purchasing bonds and foreign currency. It has ignored that the recession in Israel has been far less dramatic than in the U.S. and Western Europe, and that its interventionist policy was based to a great degree on developments in the international foreign currency market.

Bank of Israel Governor Stanley Fischer appears to be administrating a monetary policy for a country hit far harder than Israel actually has been. Fischer is helping to inflate the price of real assets (primarily real estate) and financial ones (equities and bonds).

The central bank's explanations for the purchase of more than a billion dollars within a single day are laconic and, primarily, not transparent: On Monday the central bank declared it would intervene in the foreign currency market in the event of "unusual movements in the exchange rate that are inconsistent with underlying economic conditions, or when conditions in the foreign exchange market are disorderly."

But the "unusual movements" to which the central bank referred, market pressures strengthening the shekel against the dollar, are, in fact, consistent with underlying economic conditions. Fundamental economic conditions favoring the revaluation of the shekel include the accumulation of a balance of payments credit of $4.3 billion over the past thee quarters.

Another factor is the forecast that the central bank's interest rate will increase even before such a move is implemented in the U.S. or Western Europe in response to current and expected inflation in Israel, compared to falling prices in Europe.

The Bank of Israel dramatic intervention in the foreign currency market is itself inconsistent with real conditions. Moreover, purchasing dollars in exchange for shekels creates an excess cash supply. It is also inconsistent with the Bank of Israel's decision to halt its bond buying program, a move seen by the market as signaling the beginning of the end of the central bank's policy of quantitative relief, after cutting interest rates to the bare minimum.

In lieu of a connection between the explanation given for intervention in the foreign currency market and real economic conditions, one must conclude the reason for the surprising decision should be sought elsewhere.

The Bank of Israel is not concerned about "unusual movements" in the foreign currency market; the dominant trend has been the erosion of the dollar, not volatility. The central bank is concerned about eroding export profits. This is the economy's central problem, says the Bank of Israel, reiterating its assessment that the risk of inflation is low, as most of the factors contributing to inflation to date have been one-off or a result of policy decisions, such as increasing VAT.

In this respect, the first question that arises concerns the Bank of Israel's principal function. Is it to maintain price stability (an inflation rate of 1%-3%), as implied in the stubborn battle the central bank waged over the Bank of Israel Law, or perhaps to maintain protection of export profits, which may be implied in its most recent policy move?

One thing can be said for certain. The capital market is not of one mind with the Bank of Israel's assessment that the risk of inflation is not a problem. The market is forecasting inflation of 2.95% for the next 12 months, 3.12% for the next two years, and 3.02% for the next three years.

The Bank of Israel has not persuaded foreign banks either, which continue to issue forecasts of the shekel strengthening against the dollar to around NIS 3.60, in light of relatively positive indications for the Israeli economy. The banks are recommending selling dollars now at the relatively high exchange rate of NIS 3.87, waiting for the intervention policy to fail and then buying dollars at NIS 3.60 or less.

Nor is the Bank of Israel concerned about the cost of the intervention in the capital market which, down the road, could be substantial. The central bank is buying dollars and placing them in deposits earning 0.25%-0.4%, soaking up the resulting excess shekels by accepting 0.5% deposits from commercial banks. At this stage the difference in interest rates is minor, but if the Bank of Israel is forced to increase its interest rates, for instance in the event of continued price increases, this difference will grow, and the budgetary price of this current intervention in the foreign currency market will balloon, mainly because foreign currency reserves are high.

Exporters have indeed taken a beating in recent weeks. The shekel is strengthening against the dollar, and some export markets are suffering sinking demand and falling prices, even as prices in Israel increase. Nevertheless, it may be worthwhile to consider whether the Bank of Israel's policy is the best value for every dollar it buys, in terms of benefit to the exports market, or whether there are perhaps more pinpointed and efficient ways to help exporters.

In other words, instead of subsidizing the product (the dollar), perhaps it would be worthwhile for the Finance Ministry to try to assist exporters by reducing the cost of labor in the export sector or by providing exporters with state guarantees for credit risk insurance. The Bank of Israel could help exporters by improving the shekel's real exchange rate, in other words, the real remaining value left to exporters. One way to do this would be to lower inflation, which - as the central bank may have forgotten - is the Bank of Israel's main function.