Taking Stock / Klein's Small Smile

And here is the forecast: It'll be a fiery summer in the swamp of Bank of Israel-Finance Ministry relations.

Intermittent mud-showers will be interspersed with fiscal frowns, as the two government bodies are in a very different mood, and subjected to entirely different pressures. And that, dear reader, is a recipe for trouble.

Bank of Israel Governor David Klein is famously hard to read. His tone is monotonous, every few minutes he releases a tight smile, and if his body language screams anything, it's understatement.

But it's all a show, as his cronies know. When he smiles, it usually means he's shredding some claim postulated by his partner in conversation, or opponent. And if he gestures, it is when he's dismissing entirely some idea propounded by others.

If you've been listening to him carefully lately, you couldn't get his message wrong. The governor is in no mood to assuage or compromise. A year-and-a-half before his contract expires, he's back to being his stubborn, even irritable old self, in his quiet, amiable way.

When Klein is asked about that "deal" he struck with the prime minister in December 2001, he marvels at your choosing to dwell on ancient history. But the truth is, that old wound still burns, and central bank policy is determined in its shadow.

Klein's speech at TheMarker Forum Tuesday on the financial markets hinted broadly at the guidelines for the months to come.

l The chance of rapid interest rate cuts is slim. Not only does Klein rule out accelerating the pace, but also he noted that he has no final target for interest rates.

If you thought Israeli interest rates would sink to abut five or six percent in a few months, figuring it's only a question of how many months, you may be disappointed. Klein clarified that he will re-judge the issue each month, depending on the circumstances. And those, he noted, tend to change.

The treasury had thought the last station was at 3 percent, just 1 percent above interest on the euro. Wrong. That isn't where the central bank is going.

Deputy governor Meir Sokoler clarified that as much last week. "The nominal rate of interest relevant to Israel isn't Europe's, and certainly not America's," he said. "It is the rate in countries such as Sweden or New Zealand, plus some risk premium." Interest in Sweden is now at 4 percent, and 5.25 percent in New Zealand.

Opening up a second front

l The U.S. loan guarantees are the main reason for the celebrations on the capital market, and one of the main reason investors are returning to Israeli government bonds. They are also the main factor for lowering long-term interest rates.

But Klein notes that the treasury apparently doesn't mean to use the guarantees to recycle its domestic debt. Meaning, the central bank will have to offset the influx.

He also explains how he will offset that inflow - by issuing short-term Bank of Israel certificates. So, while the left hand lowers monetary interest, the right hand may step up makam issues, maintaining high interest rates in the financial markets.

l It's time to dismantle the banks' empires. On that, Klein and Finance Minister Benjamin Netanyahu agree. To advance the capital market, the provident funds must be split off from their parent banks.

So must the mutual funds, Klein adds, thus assuring another front of warfare with the banks, which make much of their profits from running the mutual and provident funds.

The separation would be a dramatic move. It would change the face of the capital market. The only question is whether the finance minister really is determined to see it through, quickly, or whether pressure from the banks will lead to a compromise stretched out over years and years, during which time the banks will, again, kill and bury the initiative.

To sum up, Klein sees no great reason for optimism based on the resurgence of the financial markets in the last few months or the dropping interest on government bonds. That, he says, merely serves to indicate the importance of financial stability.

While Netanyahu celebrates his successes, Klein looks over the horizon and sees clouds of uncertainty, difficulties, obstacles, and elephantine government deficits.

Unless Klein and Netanyahu work hard to establish a dialogue, to coordinate their expectations and mainly their messages to the market, we are probably facing another season of bitter battles between the central bank and treasury: battles that nobody can win but have clear losers - economic policy and the economy.