Bank of Israel Chief Fights Pressure to Raise Interest Rates

Karnit Flug is loath to increase rates in an economy suffering many months of deflation.

Moti Bassok
Moti Bassok
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Bank of Israel Governor Karnit Flug.
Bank of Israel Governor Karnit Flug.Credit: Olivier Fitoussi
Moti Bassok
Moti Bassok

Bank of Israel Governor Karnit Flug has resisted pressure from Finance Minister Moshe Kahlon to raise interest rates to stem surging housing prices – in recent weeks behind closed doors and now more out in the open.

Flug said this week the bank’s policy of very low interest rates would continue for a long time. And she probably didn’t know that the November consumer price index would come in so low – minus 0.4%, as announced on Tuesday.

But she did know that it would be a long, perhaps very long time until annual inflation moved from negative territory to the government target of 1% to 3%.

Tuesday's announcement fell well below expectations of either minus 0.1% or no change at all, leaving Israeli deflation for the past 12 months at 0.9%. Economists and analysts expect the trend to hold for the coming months.

As a result, labor federation chief Avi Nissenkorn tells Kahlon at every meeting to raise wages because the public has no money to buy things. Kahlon, in turn, wants higher interest rates to keep Israelis from taking out mortgages.

Deflation is an extended state of falling prices that stems from slowing economic activity, a decline in buying power and reduced demand. People don’t buy because they have no money or expect prices to drop more.

Finance Minister Moshe Kahlon, May 18, 2015.Credit: Gil Cohen-Magen

When they don’t buy, there is no demand and prices drop. Even then they don’t buy, expecting further price falls.

When people don’t buy, plants fire workers or shut down. Demand weakens even more and the economy slows further. Israel has never suffered a deflationary regime, and persistent deflation can destroy an economy.

It’s thus very likely that the Bank of Israel will take an extreme measure at the end of the month: quantitative easing – buying government securities or other securities in an effort to increase the money supply.

In the meantime, the central bank will closely follow local and global economic developments, including the U.S. Federal Reserve’s position on raising interest rates.

Many people in the economy believe the price drops are temporary and a turnaround is imminent. They refer mainly to the price drops for imported goods, especially fuel. Of course, that’s something good for consumers.

The price declines also have domestic causes, such as the lowering of value-added tax by one percentage point this year, reductions in electricity and water rates, and soon the 1.5-percentage-point decrease in corporate tax.

Those who believe that deflation isn’t the new normal note that November is normally a month of modest price rises; consumer prices fell 0.5% that month in 2012.

The coming indexes will tell the direction of the economy, which is very likely to need the assistance of the treasury and the Bank of Israel.

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