With Base Rate at Zero, Bank of Israel’s Options Narrow

One is to pray the Fed begins raising rates; another is to take a stab at quantitative easing. A third is to step up dollar purchases. All present problems.

Emil Salman

Over the last few weeks no fewer than 16 of the world’s central banks have lowered their base lending rate. The banks are fighting a resurgence of the currency war, each trying to weaken its currency in order to encourage exports and growth.

The Bank of Israel joined the free-for-all on Monday. Governor Karnit Flug and the bank’s Monetary Committee realized that it was a fight they could not avoid. Israel can’t afford to let the shekel strengthen as it had been since the start of the year. Otherwise exports would suffer and so would the broader economy.

The result is that the Bank of Israel’s base lending rate, which had been at a life low of 0.25% for six months, is now just a shade above zero: 0.1%.

The rate cut took the financial markets by surprise, but the currency wars weren’t the only reason for the unexpected move. Israel has also been suffering deflation, like much of Europe, with the consumer price index down 0.5% in the 12 months through January. Last month alone prices dropped an unusually sharp 0.9%.

Prices will likely fall again this month, too — economists estimate between 0.4% and 0.6%. That will mean the CPI will have fallen as much as 0.9% in the 12 months through February. Only in March is inflation expected to resume.

Central banks are usually warring to prevent inflation, or at least too much inflation. But actually, deflation is just as bad or worse. Thus the Monetary Committee lowered the interest rate in order to spur borrowing and economic activity with the hope of bringing inflation back to the government’s target of 1% to 3% annually.

The Bank of Israel has said of late that it can sometimes miss the target in order to retain operational flexibility. In 2014, it missed by a wide margin, and Flug doesn’t want to repeat that this year or next.

The mortgage problem

According to the Bank of Israel, the halving of the rate to 0.25% as the Gaza war waged last summer was a key reason for the economy’s quick rebound from the fighting. But even with growth surging ahead at a 7.2% annualized rate in the fourth quarter, according to preliminary estimates, growth for all 2014 was just 2.9%, well below Israel’s 4% to 5% potential rate.

Normally such pump-priming efforts are shared by the central bank and the treasury. The first contributes via monetary tools, like lower interest rates, the second via expansive fiscal policy; that is, increased government spending.

But the Knesset broke up in December for the election without approving a 2015 budget, so the government is operating based on 2014 spending. Flug has been left to carry the baton of economic growth and ensure low unemployment and Israel’s ability to compete in international markets. Fighting the currency wars is part of the job.

But there is a price to pay for fighting the war. By lowering interest rates again, Flug is lowering the cost of taking out a mortgage and encouraging more demand for housing. And home prices already rose 5% last year. The bank has tried to neutralize the effect of cheap mortgages by tightening the terms for getting one, but the policy has not been an overwhelming success.

Avia Spivak, a former Bank of Israel deputy governor and now professor at Ben-Gurion University, doesn’t blame the central bank.

“Does the Bank of Israel need to be more sensitive to the problem of housing prices? The answer is that it’s impossible to cope with all the problems facing the economy with a single tool,” she said. “The fact is, the banking supervisor is coping with the problem of housing by imposing various limits” on mortgages.

Low interest rates have also had an impact on the capital market, which like real estate has been on fire for many months. M1 money supply has surged 40% in the past year as people choose alternatives to holding money in the bank at low interest rates.

The Bank of Israel’s base rate is near zero, so what does that leave Flug to do next? Avi Ben-Bassat, a former treasury director general and senior Bank of Israel official, says the options are limited.

“The Bank of Israel’s freedom of action is over. We’re a small economy. We won’t succeed where bigger economies haven’t succeeded. We need to respond to what the big economies are doing so we’re not hurt,” said Ben-Bassat, who now lectures at the College for Business Administration. “Fortunately for us we’re in a slowdown while big developed economies are in a recession.”

Hopeless currency war

The Bank of Israel is expected to step up foreign-currency purchases, which began under Flug’s predecessor Stanley Fischer, to offset the effect of natural gas on the exchange rate as Israel’s imported-energy bill and the need for dollars to buy it shrinks.

Fighting the currency war, as the Bank of Israel knows, is hopeless. A central bank can succeed occasionally, but over time Israel, like any small country, can’t fight the global markets and economic fundamentals. The latter – Israel’s current-account surplus and a strong, steady flow of foreign investment – favor a strong shekel.

Flug’s problem was evident just two days after the rate-cut announcement. The dollar and euro both strengthened sharply but by Wednesday were weakening again. On Thursday the dollar’s Bank of Israel rate was 3.9330 versus 3.952 on Tuesday.

On top of that, Israel’s swelling foreign-currency reserves come at a cost of billions of shekels for the Bank of Israel.

One thing the bank can do is pray – pray that the U.S. Federal Reserve will begin raising interest rates as soon as next month. But the odds of that happening – as Fed chief Janet Yellin signaled this week – are near zero. The latest estimates are that the first rise won’t occur into the final quarter of 2015, or maybe not until 2016.

The other option for Flug is to undertake quantitative easing. QE aims to put more money into the economy by the central bank’s buying of government bonds in the market.

The Bank of Israel’s Monetary Committee has examined this idea a few times but has rejected it. The 2010 Bank of Israel Law lets it engage in QE, and the Fed has been doing it since 2008, spending more than $2 trillion. The Bank of Japan has been using QE policies and more recently so has the European Central Bank.

How effective QE can be is a matter of controversy, so the Bank of Israel hasn’t rushed to pursue it. For now, it has no pressing reason to risk QE, but in today’s volatile economic environment that may change.