Behind a Wordy Interest Rate Cut, a Sop to Industrialists

The Bank of Israel had a long list of reasons for its surprise decision, but most of them don’t make any economic sense.

Eytan Avriel
Eytan Avriel
Eytan Avriel
Eytan Avriel

Anyone with a nuanced sense of humor might have been amused Monday, even to the point of laughing out loud, by the Bank of Israel's explanation of why it was lowering its base lending rate from 1.25% to just 1%. The press release does not provide much in the way of exact details, and downplays the major story.

"Monetary committee reduces October 2013 interest rate by 0.25%, to 1%," the Bank of Israel announced. Its headline should have been: “We’ll be throwing around a bunch of words on interest rates and economics so no one understands that all we’re interested in is strengthening the dollar and helping manufacturers." Don't believe it? Think I'm blowing things out of proportion? Let’s analyze the announcement, just as hundreds of American economists pore over every word in interest rate announcements by the Federal Reserve as if it were a page of Talmud.

Let's start with the most important paragraph of the announcement by Karnit Flug, who is acting Bank of Israel governor until a replacement for Stanley Fischer is (finally) appointed: "The decision to reduce the interest rate for October 2013 by 0.25 percentage points, to 1%, is consistent with the Bank of Israel's monetary policy, which is intended to entrench the inflation rate within the price stability target of 1%–3% a year over the next 12 months, and to support growth while maintaining financial stability."

How many inaccuracies are there in this sentence? First, lowering the interest rate is not at all consistent with entrenching the inflation rate within the target range, because up to now it was already in the target range. Inflation in Israel and the Western world is low to negligible, and a few tenths of a percentage point one way or another won't matter. And if it did matter, reducing the rate to such a low level could fuel a price bubble and increase inflation, so this is simply an irrelevant argument.

Second, reducing the interest rate will do nothing to support growth. A lower rate can reduce the cost of business borrowing, and the Bank of Israel has emphasized that the forecast for growth has been curbed somewhat, but in practice, economies don't work that way. The market is already divided into two kinds of businesses. On one side are major companies with access to money that get financing at low rates from the banking sector and the capital markets. On the other side are small companies (and medium-sized ones that are in bad financial straits) that don't manage to get credit anywhere, no matter what the interest rate is. A change of 0.25 points will not change that reality. At the same time, members of the public will be earning less in interest (actually almost nothing) on their savings. In real terms, adjusted for inflation, interest on savings will fall further into the negative column, hurting consumer spending power.

Third, "financial stability" will not be improved in the least by lowering the rate by a quarter of a point. What does one have to do with the other? In fact, access to cheaper capital prompts risk taking and irresponsible borrowing, not only by the super-rich and the companies but also by individual households. It will make mortgages cheaper and further inflate the real estate bubble. Such cheap capital - or in other words, a low 1% rate, which in real terms means a negative interest rate - simply encourages a credit bubble, a price bubble and financial instability. The argument that lowering the interest rate is "consistent" with financial stability is simply nonsense.

No fresh approach from Flug

The Bank of Israel statement uses wording from the Fischer era and doesn't indicate that Flug is going to be trying a fresh approach, as might have been expected. And there are more inaccuracies. Take "The Bank of Israel will continue to monitor developments in the Israeli and global economies and in financial markets, particularly in light of the continuing uncertainty in the global economy."

Uncertainty? Well, yes, but the global economy is in much better shape now than it was a year ago, when the interest rate here was 1.5%. German Chancellor Angela Merkel has won reelection and the economic situation in Europe has stabilized. In the United States, the jobless rate has declined and consideration is even being given to reining in the Federal Reserve's policy of printing money to buy government bonds.

And what about the financial markets? They have recently chalked up a five-year record performance amid an air of optimism among traders. So is it necessary to pile on with lower interest rates?

The central bank cites recent decisions by the Federal Reserve as an additional factor in lowering the interest rate in Israel: "The Federal Reserve announced that it will continue its quantitative easing program at the current volume, until additional evidence accumulates that indicates that the improvement in economic activity will be sustained. In light of the deferral of the tapering process, the uncertainty about its precise timing, its strength, and its consequences continues."

This explanation isn't particularly good either, because if the 1.25% interest rate was good for the Israeli economy before the Fed announced that it was considering tapering off its policy of quantitative easing, why is it no longer appropriate? Just because the tapering process has been deferred by a few months? No less a figure than Stanley Fischer said earlier this week that he expects the Federal Reserve to reduce its monetary incentives in a moderate fashion before current chairman Ben Bernanke leaves office in January.

Luring in first-time buyers

Back in Israel, the central bank goes on to say that it "will use the tools available to it to achieve its objectives of price stability, the encouragement of employment and growth, and support for the stability of the financial system, and in this regard will keep a close watch on developments in the asset markets, including the housing market." I have already discussed the first three objectives, but what about the housing market?

It's very nice that the Bank of Israel will be keeping a close watch on it, but lowering interest rates further will only make the high cost of housing worse. It will lure more first-time buyers into a credit trap with low rates, even if it's not clear how they will make their mortgage payments when interest rates go up. And that poses a risk to the entire banking system.

So what's the real reason the Bank of Israel lowered the interest rate? To halt the continued strengthening of the shekel against the dollar and other currencies after the greenback sank to NIS 3.50 on Friday. A strong shekel makes Israeli exports less competitive, but in principle, lower interest rates curb demand for the shekel and reduce its value.

The bottom line is that exporters here have a strong lobby that knows how to apply pressure on the Bank of Israel, Finance Minister Yair Lapid and Prime Minister Benjamin Netanyahu.

And if anyone thought for a moment that Karnit Flug was some kind of dangerous socialist, she proved otherwise on Monday.

Bank of Israel building. Credit: Emil Salman

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