Bottom Shekel / First Put Out the Fire

There is a large room in the basement of the Bank of Israel. Long shelves run along its walls. On them are stacked piles of new bills.

Billions lie there, shekels not in circulation yet, awaiting use by the Bank of Israel. From today, some of that money will evidently enter circulation following Governor Stanley Fischer's decision to buy government bonds on the open market.

The acquisitions supplement the interest-rate cuts of recent months, to the historically low level of 1%. Fischer realized his rate cuts weren't having the impact he'd hoped for.

The cuts didn't filter down to customers, be they businesses or households; not to the degree he'd sought. They got swallowed up in the banks' profits (as banks paid less for their sources but kept their rates high.)

The Bank of Israel sets short-term, not long-term rates. Its cuts didn't filter through to long-term rates - that was the problem. Those stayed high, and long-term rates are what affect employment and growth.

Long-term interest rates of a year or more are based on the yields on government bonds. This is where the central bank's latest move comes in.

In Israel, the gap between short-term and long-term rates has been very wide - 3% to 4%. The gap shows that major investors don't believe the Bank of Israel will hold interest rates low for long. They also believe that the government will be running a heavy deficit this year, and will therefore be issuing a lot of bonds to finance its activities.

Fischer aims to lower yields on government bonds. If the Bank of Israel is buying government bonds, their price will rise and their yields will fall, which in turn could impel investors to move from government bonds (which become less alluring) to other investment avenues.

As yields on government bonds fall, so would long-term interest rates. That's the idea. It demonstrates how determined Fischer is to minimize the intensity of the recession.

There is a price. Putting some of that nicely stacked cash into circulation will increase the money supply, which could lead to inflation in the future.

It's also true that the Bank of Israel could soak up the excess liquidity by issuing short-term makams.

But forget that for now. The Bank of Israel has a fire to put out. Later it can inspect and repair the damage it does to the carpeting.