Confessions of a central bank

Imagine this: It's the middle of the budget year. The government had promised not to exceed 3% deficit compared with the gross domestic product, but it's already reached 6.3%. It admits it will end the year on a 4% deviation from the target.

What would that nation's chief central banker say about it? It would say nasty things about the government, we may assume.

That is not Israel's situation. The one that missed the target so egregiously was not the government, it was the central bank. According to its semi-annual inflation report, published today, the government inflation target for 2003 was 2% to 3%. But inflation climbed to 6.3% in the first half and the central bank estimates that its deviation from target will be 4%.

That is the biggest deviation from target in the Bank of Israel's history.

If it had missed from the bottom, that would have been one thing. But inflation is higher than the target this time.

What is our chief central banker saying about it? Mainly, he's saying nasty things about the government.

Share and share alike

The report's second paragraph brings the sorry figures, and by the third, the central banker's snit starts hitting the fan. The Bank of Israel accepts responsibility for the bit from December 2001, when interest rates were lowered by 2%, until the end of February, when everything becomes the fault of the government and the Finance Ministry.

The Bank of Israel also accepts responsibility for the 10% devaluation of the shekel that began before the grand plan of late December, when expectations of a major rate cut began to develop, through to early March. It also takes the blame for the 2.4% inflation that accrued during that time.

But the additional 6% weakening of the shekel, boosting the dollar to almost NIS 5, and inflation since then to 3.9% - no, that's the government's fault.

Great expectations

The shekel's devaluation and resultant inflation from December to March, the central bank says, had to be expected in view of the changes in relative yields on the capital market. Specifically: the narrowing of the gap between yields in shekels, to yields on foreign currency assets. Clearly, the change in relative yields, the central bank explains, would engender adjustments in the public's investment portfolio, which would spark devaluation and inflation.

Governor Klein's decision in December 2001 to lower lending rates on central bank sources by 2% was mainly due to the government's promise to meet its 3% deficit target in 2002, and to reduce its deficit further over time.

The shekel's devaluation and resultant inflation after March, the Bank of Israel opines, derived from the public learning that "budgetary policy had not been updated in a manner that would restore the deficit to a decreasing pattern, as agreed (ie 3% of GDP NL) and that the private bills had not been abolished".

It also blamed Israel's deteriorating security situation, and the government's proposed Bank of Israel Law amendment, which would have made monetary policy the province of a council rather than the governor on his lonesome, thus curtailing the central bank's independence.

But the whole point is that the Bank of Israel never did have control over the government's budget policy. If anything, the central bank and government frequently quarreled over it. Sometimes the central bank tightened up its monetary policy precisely in order to neutralize, insofar as possible, the inflationary effects of the budget, as it grasped them.

Therefore, in February and early March, the market expected that the governor would kick up lending rates quickly when the government deviated from its promises. Expectations of a rapid Bank of Israel response were also evident in the rapid rise of shekels yields, in the weakening shekel, and in explanations by experts.

See that sentence buried on page 11 -

Until now, the central bank rejected claims of its culpability. But today, in its inflation report, it hangs its head. A bit.

"With hindsight," the bank writes, "the monetary policy response to the ramifications to the markets of the fiscal deterioration was too moderate."

That confession was on Page 11, though. Pity it wasn't in the introduction.

Its admission was the only real news in the whole report. It was followed by an exhaustive list of its interest rate decisions during the first six months of the year.

Although the central bank admits it missed the target, and acknowledges that its monetary responses were flaccid, that's where its breast-beating stops.

The inflation report stops short of reaching operative conclusions at any level, let alone at the personal level of the governor himself.

The Bank of Israel did not analyst the effect of its botched policy on the economy. It does not state that its tardiness forced the rate hikes to be steeper, thus hampering economic activity. It does not mention that its malfunction will also hinder its ability to lower the rates.

The Bank of Israel does not explicitly state that its unfortunate policy badly eroded its credibility. It does natter on about the public's impaired confidence in macro-economic policy, but it isn't clear what it's talking about.

The Bank of Israel is consistently refusing to take the medicine it dishes out to others: It preaches that civil service wages must be cut, but lavishes enormous salaries on its functionaries. It preaches the sanctity of budget goals, and misses its targets. It critiques decisions of the government and treasury and ignores the ramifications of its own ill-guided decisions. It wants independence, but refuses to reach conclusions by itself.

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