Between the Drops

The educational process was long and more than a little painful, but eventually, former Bank of Israel governors Jacob Frenkel and David Klein succeeded in teaching the politicians and public that a basic condition for long-term growth is price stability. Current governor Stanley Fischer thinks the same.

After assuming his position in May, Fischer left interest rates unchanged for several months. However, when he learned that the chairman of the U.S. Federal Reserve Board was raising interest rates in the United States, Fischer began raising rates here, starting in the fourth quarter of 2005. Fischer's policy was to keep Israeli rates higher than American rates in order to reduce short-term outflows of capital. The result should be a halt in both the shekel's depreciation and price increases.

Interest rates influence short-term movements of capital, but there are also long-term capital flows. We are benefiting from an impressive increase in inflows of long-term capital (for investment purposes), which offsets the capital outflows. Moreover, the link between depreciation and prices has weakened greatly in recent years. The public knows that the shekel is not necessarily depreciating constantly, and therefore, merchants and manufacturers do not raise prices immediately every tiny depreciation.

2005 ended with a 2.4 percent inflation rate - very close to the middle of the government's target. But inflation was negative in the last two months of the year, and January's inflation was apparently negative as well. So perhaps Fischer is overdoing it a little? After all, it does not require great genius to follow the U.S. blindly.

Explaining why the Bank of Israel raised interest rates in February, Fischer wrote that the decision was "based on expectations of continued rises in interest rates worldwide, and especially in the U.S." And indeed, Alan Greenspan raised America's key lending rate by another 0.25 percentage points on Tuesday, to 4.5 percent, compared to 4.75 percent in Israel. The Fed's announcement added that "further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance."

The same is true here: The Bank of Israel's periodic report on inflation, which was published Tuesday, forecast additional rate hikes in the first half of 2006. Admittedly, the report insisted that the Bank of Israel is conducting an independent policy, not simply imitating the American central bank. But what we are seeing in practice is clear imitation.

After all, there are no threatening inflationary pressures here. Private forecasters are predicting inflation of about 2 percent this year. The budget is under control, there are no wage pressures, unemployment is still very high, the economy is in an upswing, and the government, astonishingly, is stable. So why should we be following the policy set by the Fed? There are plenty of countries whose economies are just as open as Israel's, and about the same size, that nevertheless dare to keep their interest rates lower than those of the U.S.

The Bank of Israel's policy recalls a saying from the Jewish sources: "a dog-faced generation." The dog runs ahead of its master, and looks as if he is leading him. But from time to time, he looks back to check whether his master is still behind him, and where he is headed. Then the dog wags his tail proudly and continues to "lead."

If Klein had conducted the exact same policy as Fischer - raising interest rates month after month and even announcing that further increases would be needed in the near future - he would almost certainly have been assailed from all sides: by the media, Finance Ministry, Acting Prime Minister Ehud Olmert, and industrialists.

But Fischer somehow manages to walk between the raindrops. Perhaps because he does not criticize the government. Perhaps because he says the situation is excellent. Perhaps because he does not get involved in controversial issues. Klein cared about everything: He would criticize economic policy, social policy and the failure to carry out important reforms. And in Israel, you pay a high price for doing that.