A Curious Cut

This article appeared in the Economist magazine edition of September 5 and on the Economist site under the headline “Shekeled and bound”.

The Bank of Israel, the country’s central bank, is seriously concerned about the state of the Israeli economy. That, it seems, is the rationale behind the decision by the bank’s Monetary Committee, at its monthly meeting on August 25, to make another 25 basis point cut in the bank’s interest rate.

This move, seemingly unexceptional, was unforeseen by analysts and by the financial markets, where short-term bond prices were reflecting no change for the next three months. The main reasons everyone was wrong-footed was that the bank had cut in July and successive reductions are very rare, while the latest cut brought the rate to 0.25%, the lowest ever. Furthermore, the impression arising from the statement accompanying the July decision was hawkish — that the cycle of interest-rate cuts begun in September 2011 was at, or near, its end.

True, in the intervening month much has happened in and around Israel, but the economic impact of the Gaza fighting was not a major factor in the latest decision — at least judging from the committee’s latest statement. This pointed instead to regular macro-economic data showing inflation at levels well below the central banks 1-3% per annum target range, while the level of economic activity was also slowing — as highlighted by the anemic rise, of only 1.7% at an annualised rate, in GDP for the second quarter.

These negative trends will certainly be aggravated by the extended period of hostilities, but they long preceded it. Israel’s formerly robust growth has been slowly decelerating since 2011, although unemployment continued to decline until very recently and the budget deficit shrank to 2.4% of GDP for the 12 months ending in June — a level not seen since 2007. But all of these positive trends have either already reversed, or seem set to do so. Meanwhile, industrial production has shrunk and — most worryingly of all — so have industrial exports.

In part, the slowdown stems from global weakness. But a key factor behind both disinflation and the decline in exports has been the strength of the shekel. The currency’s value, as measured by the Bank of Israel’s trade-weighted index, rose gradually from almost 95 in July 2012 — when the euro crisis climaxed — to below 82 in July of this year. Along the way, the Bank of Israel intervened with sporadic purchases of foreign currency, but only to ‘smooth’ the process, never to try and end or reverse it —  in line with the policy instituted by the previous Governor, Stanley Fischer, and continued by his successor, Karnit Flug.

This policy views export competitiveness as a critical national interest that must take precedence over other economic issues. Consequently, interest rates have been pushed steadily lower, despite the resulting boom in mortgage lending and surge in house prices — which the bank has addressed via administrative measures, with mixed success.

But the shekel’s value has declined in recent weeks, probably reflecting both global factors — the strength of the dollar — and domestic ones, including the deteriorating economy and the Gaza operation. The Bank of Israel has chosen to use its remaining ‘ammunition’ within the context of orthodox monetary policy, to spur this process and has been rewarded with a significant further fall in the shekel. If this holds or is extended, both inflation and economic activity will pick up, exports will receive a fillip — and all these will generate badly-needed tax revenues for a Treasury struggling to generate a 2015 budget draft that will pass the cabinet and Knesset, but also pass muster with the markets and ratings agencies.

 

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