Fool's Gold / Get It Over With

Stanley Fischer should have proven that he means to crush inflation. He should have raised interest rates for June by 0.5%, but he elected to raise the rate by a mere 0.25%. His mistake will cost dearly.

When you have to cut off the cat's tail, you don't do it slice by slice. You make one cut. It hurts less. Now Fischer will have to raise interest rates again next month, too.

He know he erred when he raised interest rates twice, each time by half a percent, in March and April this year. Fischer had relied on two assumptions that turned out to be wrong.

He assumed that the U.S. crisis would hit the Israeli economy hard, that the local economy would also slow and as a result, inflationary pressures jacking up prices would abate. It didn't happen. Israel's economy isn't slowing: GDP grew by 5.4% in the first quarter.

Fischer's second wrong assumption was that the price hikes were confined to fuel and food. That inflation was imported, a sort of external shock that could be fought through lowering interest rates. Fischer also thought that the troubles in the U.S. would depress prices of food and fuel, yet oil continued to climb.

Anyway, when the April consumer price index rose by 1.5%, the Bank of Israel realized that the situation was worse than it had thought. It turned out that not only food and gasoline had risen in price: almost everything had. This was classic demand-driven inflation, against which the Bank of Israel has a weapon. Raising interest rates.

In March and April, Fischer chose to tackle the fear of slowdown, which is why he cut interest and hoped that the dollar would rebound against the shekel. But the public thought the governor was abandoning the war on inflation and shifting to a policy of supporting the dollar. Thus expectations changed. Everybody began to believe that inflation would mount and therefore raised prices, not to be left behind, as it were. It was a classic case of self-fulfilling prophecy. And that's why Fischer should have taken firmer action yesterday. He should have made us really believe that inflation will recede to just 2% in the next 12 months. A quarter-percent won't do that.

Some think the hike will cause a slowdown. No:now expectations of further price hikes will continue and inflation will too, leading to wage demands and strikes.