Skip to main content

Bank of Israel¿s interest rate hike two days ago was inevitable. Investors, lenders, dealers, manufacturers, consumers and everyone else in the foreign currency market, the capital market and the country at large, forced it on the central bank.

Ever sin ce Bank of Israel governor David Klein left Prime Minster Ariel Sharon¿s office with a decision to cut key lending rates by 2%, public faith in economic policy in general and in Bank of Israel in particular, has begun to erode.

The public told Klein: We¿re nervous, we don¿t understand the move or your justifications, and , in short, don¿t understand what happened to you.

Investors told Klein: We are buying foreign currency, opening accounts in foreign banks and acquiring index-linked financial assets not only because interest rates went down, but because of the fear of the unknown ¿ of government economic policy and its economic advisor.

The business sector told Klein: We are oddly unsure of price stability and have suddenly remembered times when there were both recession and inflation. We are not convinced this one-time price rise won¿t become a continuous upward crawl.

And Klein had no choice: He understood that there is no way to know how the erosion of public faith will end. He knows that in times of increasing uncertainty, there is no choice but to broadcast commitment to price stability to the markets in no uncertain terms. So he made a U-turn and raised interest rates by 0.6%.

Klein had a long list of reason why he had to raise interest rates. They were all well and good ¿ but most were also true two months ago when he lowered interest rates 2% after a meeting with the prime minister.

Klein cannot attribute his u-turn to surprising, external events that he could not be expected to have foreseen when he made his previous decision -- so the zigzagging monetary policy hurts the central bank¿s credibility.

Yesterday¿s IMF report is symbolic. The body unswervingly supported Bank of Israel¿s economic policy for years. Yesterday¿s report directly criticizes the package deal including interest rate cuts into which the bank was dragged.

Scroll to Continue

TheStreet Recommends

The damage to the central bank¿s credibility will have a very real price: It will cause another unnecessary delay in the painful disinflation process Bank of Israel has been leading for seven years, a process characterized by higher real interest rates than accepted in the Western world.

The practical significance of the deteriorated credibility will be that Bank of Israel will need higher interest rates for longer periods in order to achieve current inflation targets. If the interest rate reduction process were transparent, responsible and supervised, without breaks for deals, we could achieve price stability and more Western interest rates, faster.

The damage to Klein¿s credibility will weaken his ability to criticize, struggle against, deal with, and advise the government. These are all important roles for the central bank, in addition to the bank¿s responsibility for monetary policy, the capital markets and the banking system.

This may be the entire affair¿s most serious damage. Today more than ever, there is a need for responsible, objective, professional, non-populist forces who won¿t be dragged behind the cabinet and the Ministry of Finance, but can warn of the direction economic policy is taking.

After the treasury blew past the deficit target in 2001 and submitted a 2002 budget based on increasing the tax burden, it is now staying on this destructive path. Any economist can tell you there was no budget cut because budget cuts are measured in terms of deficits in GDP terms.

It is clear to any economist that the basic budget assumptions are unrealistic. Tax collection will be lower than projections and there is real risk the deficit will soar to 4-5% and the Minister of Finance is ignoring reality.

Silvan Shalom doesn't have to go all the way to Bank of Israel to find out what damage stems from wanton fiscal policy. Dr. Michael Sarel, his own ministry's director for economics, wrote yesterday in a report that high budget deficits are damaging: increased public debt, rising long-interest, difficulty meeting 2003 targets and a widening gap in the balance of payments.

Until two months ago, the business sector, investors and the country at large knew the central bank was an anchor of sanity in the political sea that allowed our economy to avoid all the external and internal storms raging around us. Now that anchor is in danger and the central bank must quickly mend its image.

The economy doesn't only need it to calm capital markets, but also so the bank can return to its role as the sane dam against the politicians who live for tomorrow¿s headlines and next week¿s primaries.