Israeli Interest Rates Could Drop to Zero, Says Fischer

Unveils latest weapon: Buying government bonds

The Bank of Israel has unveiled its newest weapon in the war against the liquidity crunch: buying government bonds, starting today. Nor does the central bank quail at lowering interest rates further from their historic low of 1%, Governor Stanley Fischer spelled out yesterday.

Not only will the Bank of Israel be buying government bonds, it may start picking up corporate debt too, Fischer said. "A central bank governor never says never," Fischer repeated yesterday, referring to the possibility of buying corporate bonds as an emergency measure or possibly other assets as well.

Speaking about central bank policy before the Conference of Presidents of Major American Jewish Organizations, Fischer explicitly stated that there will be more interest-rate cuts. The Bank of Israel rate could even be lowered to zero, though it couldn't be negative, he quipped.

Moreover, the Bank of Israel plans to continue buying up dollars, Fischer said. The central bank began buying foreign currency in the middle of last year, ostensibly to shore up the foreign currency reserves but, say business leaders, also to shore up the battered dollar against the buoyant shekel. The Bank of Israel was supposed to stop buying greenbacks when reserves reached $44 billion, which is about to happen.

Fischer said, however, that he has no intention of setting a floor for the shekel-dollar exchange rate, and once the central bank stops buying dollars, the shekel might bounce against the American currency again.

In recent years Israel's governments have maintained fiscal discipline, Fischer said, meaning they didn't build up heavy deficits with irresponsible spending. He called on the new government to do the same; given the current economic straits, there's no place for budgetary expansion, he said.

Make no mistake, the economic crisis shaking the globe has arrived here too, the governor clarified. In any case, Jerusalem is going to run a giant deficit in 2009, probably about NIS 35 billion or 5% of GDP. And while the United States may be able to contend with a huge deficit by printing dollars, Israel can't print shekels.

Meanwhile, the central bank will be buying and selling various types of government bonds, of various durations to maturity, on the open market from today. The purpose is to boost liquidity at financial institutions, businesses and households, and to extend the effect of interest-rate cuts from short-term interest rates to long-term rates as well.

The problem has been that while the central bank's rate cuts affect short-term rates, their effect on long-term rates - the rates that matter to businesses and households - has lagged. The long-term rate hasn't been dropping in tandem with the overnight rate.

If the central bank buys bonds, their price should rise and the yields they offer will drop.

Interest rates on loans are correlated to yields on government bonds. Therefore, falling yields should translate into lower interest on loans, easing the credit stress for businesses and households alike.

Each month the Bank of Israel will report the total amount transacted through open-market operations the previous month.

The Bank of Israel will monitor the use of this instrument and make adjustments if necessary, it said.