Is Israel coming to the end of the current business cycle with the hands of its central bank tied behind its back?
The Bank of Israel’s main tool for countering an economic downturn is the regulation of interest rates, but at 0.25% it doesn’t have much room to maneuver. Moreover, it has to contend with multiple goals – to keep inflation within the government’s target, support economic growth and prevent an excessively strong shekel – goals that don’t always complement each other.
“Israel right now isn’t in a very comfortable place in terms of the macro-economic policy mix,” said Dr. Gil Bufman, chief economist at Bank Leumi.
“On the monetary side, real interest rates are negative at about minus 1%. On the fiscal side, the deficit has grown to 4% of GDP and the debt-to-GDP ratio is growing to more than 60%. There’s almost nowhere to lower the base rate and not a lot of room for fiscal expansion because the deficit is so high,” he said.
The Bank of Israel is expected to announce on Wednesday that it will keep its base rate at 0.25%, marking five years in which the rate has been hovering just above zero (for a long time it was just 0.1%). Such a low rate was once regarded as unusual, but it has become the “new normal” not just for Israel but for most of the developed world.
There are few signs that this is going to change anytime soon. The Bank of Israel attempted to normalize rates earlier this year, by signaling plans to raise them. But on July 31, Governor Amir Yaron raised the white flag and promised no rate hikes anytime soon.
Raising the base rate was supposed to ready the central bank to cope with an economic downturn when it comes. Israel’s economy is growing strongly and is close to full employment – a time when conventional monetary policy calls for higher interest rates. Moreover, a rate hike would have given the central bank the ammunition it needs when a slowdown arrives – by enabling it to lower the rate and spur borrowing and increased economic activity.
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The problem faced by the bank is the same that other central banks face and have faced in the decade since the great financial crisis: Are the monetary tools they have at their disposal relevant to the current economic situation?
Since the financial crisis, interest rates have stayed at unprecedented low levels and in some places, including the Euro zone, they are negative. Only the United States has raised them since 2015 and more recently it has reversed course.
Rates in the range of zero not only leave central banks without their main tool for addressing a downturn, they risk creating an asset bubble, particular in real estate that could precipitate a crash.
Israel’s central bank doesn’t reveal its internal deliberations, but the U.S. Federal Reserve is more open. Its chairman, Jerome Powell, offered some insights last week into how the bank was coping in this new era.
“As we look back over the decade since the end of the financial crisis, we can again see fundamental economic changes that call for a reassessment of our policy framework. The current era has been characterized by much lower neutral interest rates, dis-inflationary pressures, and slower growth. We face heightened risks of lengthy, difficult-to-escape periods in which our policy interest rate is pinned near zero,” he said at a conference in Jackson Hole, Wyoming.
“To address this new normal, we are conducting a public review of our monetary policy strategy, tools, and communications—the first of its kind for the Federal Reserve … and we are asking whether we should expand our toolkit,” he said.
The Bank of Israel also has to respond to the new normal. In the U.S. and the Euro block inflation has been below official targets of about 2% for a long time. In Israel, the consumer price index entered the target of 1-3% annually in the middle of 2018, but then it began to fall and as of July it was running at just 0.5% for the previous 12 months.
Low inflation has persisted even though central banks have engaged in expansionary monetary policies for years. This has led some observers to conclude that inflation targeting as a policy has exhausted itself.
Stephane Monier, chief investment officer at Lombard Odier Private Bank, recently suggested dropping annual targets for more flexible multi-year goals. Alternatively, central banks should consider targeting the CPI and GDP growth or – as has been recommended to the bank of Israel in the past – targeting financial assets, such as home prices.
It seems the Fed is ready to consider such ideas. What about the Bank of Israel?
“The Bank of Israel likes to stress that it has other tools, but it’s not clear that it has a lot of tools to undertake unconventional policies,” Bufman said.
He said the Bank of Israel would be justified in raising its base rate at least enough to bring an end to real negative interest rates, given Israel’s overall economic situation - except that its inflation target precludes such a move. He believes that the bank should either abandon the target or make it more flexible.
“The existing inflation target of 1-3% was fixed more than 15 years ago. Since then a lot has happened in the world. The Bank of Israel needs to needs to release the handbrake that prevents it today from considering a rate hike,” Bufman said.
Zvi Eckstein, a former Bank of Israel deputy governor, disagrees.
“If Israel wants an open and globalized economy its inflation target has to be like other leading countries,” he said. “If the target in the U.S. the Eurozone, Japan and Britain is 2%, the story is over from Israel’s point of view. The target stabilizes the shekel versus other currencies and stabilizes the economy.”
Meanwhile, the bank has quietly adopted another target, namely that the shekel exchange rate will keep to a certain range. That, however, ties it hands as far as raising the interest rate, which would only serve to strengthen the shekel.
Rather, it seems more probable that the Bank of Israel will lower the rate to 0.1% in the next few months and perhaps even cut it zero. A nominal negative interest rate, on the other hand, doesn’t seem to be in the offing. Yaron himself hasn’t expressed a view, but the bank has said the experience of other countries is insufficient for Israel to experiment with it.
Another way of pursuing an expansionary monetary policy when you can’t lower rates further is through quantitative easing, i.e., the central bank buys huge amounts of assets, such as government bonds, to make more liquidity available.
The central banks of the U.S. and Europe have spent trillions of dollars on QE. The Bank of Israel, by contrast, has only employed QE for limited periods, for example when it bought 18 billion shekels of government bonds over a few months in 2009, at the height of the global financial crisis.
This time employing QE would be more difficult. Yields on government bonds are already very low and are likely to fall lower still after Israel joins the FTSE World Government Bond Index probably early next year. Being part of the WGBI will spur foreign demand for Israeli bonds, raising prices.
“After we join the index, and if the Bank of Israel were to begin to buy bonds too, perhaps Israel would join the club of countries whose bonds trade at negative yields,” said Bufman.
Another QE tactic would be for the Bank of Israel to buy foreign currency without buying an equal amount of shekels to neutralize the impact of printing money. Bufman calls money printing a “nice idea” that hasn’t worked, at least in the U.S., where it failed to lift inflation.
Intervening in the currency markets, as the Bank of Israel has done, gets short-term results but in the long run fails. In the period December 2009 to July 2019, despite routine intervention, the Israeli currency’s real effective rate has increased 13.1%.
“The strengthening of the shekel is a long-term trend and it seems that it will continue,” said Eckstein. He said trying to reverse that trend using short-term tools, like the short-term interest rate or buying foreign currency, was bound to fail.
“In the long term, there is room for programs liken the Bank of Israel has presented for improving productivity and increasing domestic demand and ending the excessive aid the government gives to exporters so that the surplus on our balance of payments will be moderated. If the surplus shrinks, it’s reasonable to assume the shekel will weaken,” he said.