Despite the fact that the most notorious error came at the end of last December, when Bank of Israel governor David Klein decided to slash interest rates 2% in a single shot, to analyze the reasons for inflation re-rearing its ugly head, it is necessary to look at the series of events over the past year.

The Minister of Finance and cabinet's mistakes and failures in overstepping the budget deficit are known to all. The leap in the deficit and the public loss of confidence in fiscal policy are a fundamental factor in the fatal cocktail that led to inflation amid a deepening recession.

But the surprising and worrisome phenomenon is Bank of Israel's "contribution", an institution considered until recently the only anchor of stability and sanity in the economy, stubbornly cautious and planning for the long term.

Bank of Israel's first mistake came in early 2001 when it failed to identify the depth of the global economic crisis, and did not predict the speed at which the Israeli economy would skid from rapid growth to deep recession.

At the end of 2000 and the beginning of 2001, when many economists following the U.S. situation understood the economy was coming in for a landing and Federal Reserve chair Alan Greenspan began rapidly cutting interest rates, David Klein erroneously thought the situation was not too bad. "The dot.com's blew up, and that makes a lot of headlines ¿ but the American economy is still strong," he explained.

That was a mistake: the entire technology sector was riding the dot-com bubble, as were the communications sector and Wall Street, and when that bubble burst, the shock waves hit the entire economy. Klein also didn't understand how much of the strength of the "Israeli technology engine", as he called it, was drawn from Wall Street ¿ and therefore how dangerous it was to rely on the engine in analyzing Israeli economic growth potential.

Just noticed security damages

The central bank was also in no rush to recognize the significance of the peace bubble bursting; one year ago, it still believed that the price of the Palestinian uprising would not be great. Just six months ago, the bank began ot discuss damages from the deteriorating security situation.

This flawed macroeconomic analysis to be late in lowering interest rates in 2001. It is possible that had he understood the speed at which the economy would go downhill, he would have lowered rates faster, and not been dragged into the sharp 2% cut at the end of the year.

The tardiness in lowering interest rates was one reason for the miserable decision to lower key lending rates by 2%, but not the only reason. The sharp reduction, a definite deviation from five years of Bank of Israel policy, stemmed from a combination of factors.

First of all, Klein was sharply criticized for not reducing rates earlier, secondly, the prime minister and Minister of Finance began their massive pressure campaign with the monetary council threat in the background, an idea that would not only reduce the independence of the central bank, but also the independence of the governor himself and his great prestige.

Third, Klein thought a 2% lending rate reduction was a "good deal" since he received in return the almost complete obliteration of the currency fluctuation band and removal of the short-term debt ceiling ¿ two thing she had waited many years to receive and which make Bank of Israel policy far more effective in the long run, allowing far greater maneuvering room.

Fourth, Klein got Sharon's promise of a significant budget cut. He was apparently under the delusion that the prime minister was determined and would therefore come up with the goods. In the worst case, Klein thought to himself, we can always raise rates again after we¿ve got the fluctuation band and debt ceiling in hand.

Short in communication with market

What Klein did not expect was the fatal combination of the cabinet's inability to cut the budget, the worsening Palestinian uprising that left particularly the currency market very vulnerable, and financial markets' astonishment at the sharp interest rate reduction.

For the first time in many years, market players felt they didn't understand central bank policy. After years of good communications with the markets ¿ there was suddenly a short.

In order to understand the damage to the credibility of economic policy when financial markets are "surprised", we needn't go further than Klein's own articles. Over the past few years, he has reiterated that the age in which economic policy is based on "surprises" has passed from the world.

In a June 1997 article, "Should monetary policy resemble Giselle or Taming of the Shrew?", Klein compares the pace of interest rate reduction to the two ballets, calm "Giselle" and stormy, tempestuous "Taming of the Shrew".

The article, one of Klein's wittier, mocked those who advised Bank of Israel to raise and lower interest rate quickly to adjust them to the variable market situation.

"On Wednesday morning you lower interest at 9:00 am by half a percent and go outside to see if anything happens. If it is too difficult to set forth alone ¿ send the dove to see if the foreign currency floods have stopped and the shekel ocean is beginning to dry up. At 11:00 am you see nothing is happening, so you lower rates another half percent. Then call it a day and wait to see how the public acts and what the media says. The next morning, when the shekel ocean is still as deep, you muster some courage and lower lending rates another half percent before lunch, and another half just before the evening news".

Markets sensed Bank of Israel's commitment to price stability weakening

And so Klein mocks all those who recommended the central bank cut rates quickly and "react" to varying market conditions, and he summarizes with a clear message. "One of the fundamentals of macro economic policy, in our opinion, is incorporated in the term 'stability': the policy's goals must be as clear and well-known as possible, as long term as possible, with necessary adjustments made in due course, in moderation, and not in large doses ¿ to think in terms of interest rate changes initiated by the government, every few hours, at 'varying times' and with an element of surprise, that would be the embodiment of craziness".

The 2% December interest cut, Taming of the Shrew-style, began the erosion of the central bank's credibility. A month after the reduction, with the shekel in freefall, it was already clear the governor had erred. But Klein, instead of making a sharp about face and signaling the markets he understood the error of his ways, continued to dillydally and hope the high consumer price indices were "one-time" events. The rate hikes that followed didn't calm the markets, which felt Bank of Israel¿s commitment to price stability had weakened.

The price of Bank of Israel's monetary error will be that the coming year will need higher interest rates to achieve the same inflation targets. 2002, which was supposed to be the first year with low inflation and interest rates, will be a year with high inflation and interest rates.

But 2002 is already a lost cause, the question is if Bank of Israel will manage to regain its credibility in the coming months, so that next year the central bank can lower interest rates again, Giselle-style, slowly and cautiously, again becoming the anchor of price stability.