The decision this week by the governor of the Bank of Israel, Dr. David Klein, to raise the interest rate by 1%, was made, according to a statement released by the bank, "to restore the development of inflation to the realm of price stability" - in other words, to keep inflation below 3%. Since the beginning of the year, Israel has experienced what analysts called an "inflationary outburst," reflected in a rate of 3.9%, which is higher than the inflation rate target for the entire year. Klein cannot accept this, especially in the wake of his disappointment in the deal he cut with the prime minister and the finance minister last December.
At that time, it will be recalled, Klein slashed the interest rate by 2%, based on the understanding that the government would return to "a policy of fiscal restraint and a declining path for the deficit and the public debt in the next few years." The bank's point of departure was that its partners to the deal would keep their word, in which case the foreign currency market would stabilize and the inflation rate would return to the sphere of stability.
The governor is not now saying explicitly that his partners to the deal failed to live up to their commitment. Instead, he refers to the "continued laxness of the government's fiscal policy," which is, of course, bad. However, the government sensed this laxness very quickly and drew up an ambitious plan to close a "budget gap" of NIS 13 billion; that plan is now in the process of being approved by the Knesset. Unfortunately, the governor lost his patience and restored the interest rate back to almost exactly what it was on the eve of the deal last December.
The question is what brought about the "inflationary outburst" of January-April: was it in fact the "continued laxness of the government's fiscal policy"? A close examination of the cost-of-living (c-o-l) indices shows clearly that the direct cause of most of the price rises has been the dollar.
The dollar, which became more expensive - meaning the shekel was devalued - generated price rises that are both direct (such as rent and the cost of flights abroad) and indirect (a huge range of goods and services that include foreign currency elements). From January to April, the rate of the foreign currency basket rose by about 11%; so is it all that surprising that in this period the inflation rate increased by 3.9% in an economy in which imports total about 40% of the gross domestic product? Treasury officials say that if the effect of the dollar is deducted from the c-o-l index, the rise in prices does not exceed the "stability target." The deep recession supports this assessment.
The key, then, is the dollar, and the key question is why the dollar rose. One could, of course, argue that the "continued laxness of the government's fiscal policy," with all that this entails, is a contributing factor to the surge of the American currency. However, it stands to reason that the major factors are related more substantively to the foreign currency market. On the one hand, we know that the foreign currency supply in Israel shrank drastically, for two reasons: the worldwide hi-tech crisis and the security situation.
On the other hand, demand increased following the sharp interest rate cut in December 2001, on top of which Israelis have had almost unlimited overseas investment opportunities since mid-1998 and it was only to be expected that this potential channel would be exploited more intensively as the recession deepened and the security situation worsened. So there could be nothing more expected than the increase in the price of the dollar.
In fact, the governor also knows that the key to the situation is the dollar. In its statement, the Bank of Israel reminds us that following the steep rise in the dollar rate in the wake of the interest cut last December, the governor intervened by announcing that the central bank was determined to maintain price stability, by warning against losses to be expected by those who would purchase dollars rashly (those who ignored his warning in fact made a profit) and by raising the interest rate by 0.6%.
Supposedly the dollar obeyed and stopped its spurt around the middle of February, but this was a very brief development, as the devaluation resumed within days and the c-o-l index rose precipitously as well. It was then that the governor reached the conclusion that the bank had no choice but to take a drastic step, in the form of a full 1% interest rate hike, which was announced this week.
Will Dr. Klein's battle against the dollar by means of the interest rate produce the intended result? The major reason that Israelis purchased dollars was, and remains, the temptation to invest abroad, a temptation that has been spurred by fears of a further deterioration in the security situation. This is the major cause of the developments, and not the "continued laxness of the government's fiscal policy" - which in fact seems to me on the verge of ending.
What will induce Israelis to stop stocking up on foreign currency? Will the differential that was generated this week between the short-term interest rate of the U.S. Federal Reserve and the interest of the Bank of Israel (3.85%) - a differential that will increase if the interest rate is raised further - persuade Israelis to return to shekel-based investments? That is very unlikely.
The attempt by the Bank of Israel to do battle against the dollar by raising the interest rate would appear to be a hopeless venture. The only result will be to further aggravate the economic situation in the midst of a serious recession. If the price of the dollar shoots up beyond what is "reasonable," other means will be needed in order to cope with the situation.