The three arms of economic policy trying to ensure Israel's economic stability are actually having the opposite effect. Fiscal discipline, high effective interest rates, and wage erosion are pushing the economy into recession. How necessary is it for all three arms to work at once?

Fiscal discipline is necessary to prevent the government from breaching its deficit, which would lift long-term interest rates and undermine Israel's international status.

Wage erosion is necessary to prevent the civil service budget from bloating even more, and to decrease the burden on the business sector.

High effective interest is necessary to prevent inflation, mostly by keeping interest on the shekel much higher than interest on the dollar, thus damping the demand for dollars.

But does high interest really keep prices in check? The so-called "inflation" in the first half of 2002 was caused by the shekel shrinking to almost NIS 5 per dollar. But that was caused primarily by the sense that the government had lost control over the economy, together with terrorist attacks, and fears of a wider military flare-up.

The year began with nominal interest of 3.8% on central bank sources, which the central bank quickly kicked up to the present rate of 9.1%. Those increases were presumably the factors that ended the price hikes, leading to a negative consumer price index in August. But what really calmed the market was the shekel's gain in strength to trade below NIS 4.7 against the greenback, due to a cabinet decision on a budget cut, and relative calm on security fronts.

The claim postulated here is that the monetary factor's impact on the shekel is marginal.

Since the dollar's exchange rate in Israel is the primary factor behind price rises, and since it is affected primarily by non-monetary factors, there is little point in using interest rates to curb price rises.

Can lending rates handle escalation in hostilities? Or the government's loss control of the economy? And does the shekel's devaluation stem from that?

The Bank of Israel happily advised Israel last week that inflation expectations for the coming twelve months are 2%, and the sharp CPI rises of recent months were an anomaly that will not repeat itself.

Really? How does it know there will be no political or security setbacks that will again squeeze the shekel below NIS 5 to the dollar, again causing "inflation"? Last week the shekel sank anew, despite the sky-high effective interest rates.

The Bank of Israel already reached conclusions on the limitations of inflation expectations and no longer gives them the weight they once carried. Changes in the means of payment have earned the same treatment.

So on what basis are interest rate decisions made? It appears they are based mostly on intuition, reflecting the mood at the central bank, and based on the hope they will carry psychological weight.

But if the exchange rate is the primary factor in "inflation" in the recessed Israeli economy, and if exchange rate fluctuations are primarily affected by non-monetary factors, maybe it would be better to give up interest rates as a means of regulating inflation - and make decisions on this all-important matter based on considerations of the actual economy?