Raise rates now - TheStreet

Bank of Israel governor David Klein has fantastic explanations for all the central bank's moves in the past half year; he can list the Ministry of Finance's errors, detail why analysts and economists are wrong and why is the central bank is not responsible for the rapid shekel devaluation.

There is only one thing he hasn't managed to explain yet: why inflation is up 3.9% since the beginning of the year and why economists project 2002 will end with 6-7% inflation, twice the government's inflation target.

Klein can pass the buck to the treasury, the Nasdaq or the Palestinian uprising, but he, better than any other economist, knows that the responsibility for inflation is his and his alone.

That is after all the Reader's Digest version of his war with proponents of the Bank of Israel amendment: he demands that Bank of Israel be committed to a single goal ¿ price stability. It is now clear that Bank of Israel, which has had complete independence until now, cannot meet the one target on which it is focused.

Bank of Israel policy is not the cause of accelerated inflation, the rapid shekel devaluation and concomitant price hikes stem first and foremost from the deterioration in the security situation, the deep recession, fiscal frivolity and loss of public confidence in Ministry of Finance policy and the prime minister¿s commitment to the economic matters.

But Bank of Israel, supposed to be the damper, the anchor of stability ¿ disappointed. Instead of checking the slide, the bank caused market jitters and the loss of investor confidence with the miserable decision to slash lending rates by 2% in December 2001, and then with a series of rate hikes that were too little, too late.

For the past few months, Bank of Israel has maintained too low effective interest ¿ interest that was inconsistent with inflation targets considering the economic situation and financial market nervousness. For several months now, Bank of Israel has had poor communication with the markets and has been dragged along by them instead of showing them the way.

Our conclusion, for a change, is very simple: Klein must stop threatening, warning and playing the tough guy. It doesn't work anymore, he has lost points on the financial markets and now it is impossible to get results by talking. If he wants to shoot, he should shoot, not talk. The time has come for a sharp interest rate hike and clear message to the markets.

Will it help? Yes, there is a good chance it will help. In the past five years we have learned that monetary policy works in Israel just like it works the world over, if there is credibility, if there is commitment, then there are results. And all the talk of the "Israeli economy working differently" has been shown to be void of all meaning.

Can the financial markets calm down even without a rate hike? Can we return to price stability without a sharp, immediate rate hike? Yes, but it¿s not worth the risk. That is what Klein did in recent months ¿ at any given moment he preferred to wait and hope for the best and the economy has paid a heavy price.

Is it possible that the devaluation will continue and prices will continue to rise even after a rate hike? Yes, the past half year has eaten away at the central bank and treasury's credibility with unsubstantiated projections, lack of fiscal discipline and the Minister of Finance and Prime Minister's general financial behavior. It is certainly possible we are approaching the moment when monetary policy is simply not effective if unaccompanied by dramatic fiscal measures that will restore public and investor confidence in the economy.

Can a sharp rate hike cause further damage to an economy already mired in recession, will it amount to "leg irons" as Finance Minister Silvan Shalom called it?

No. That is just another one of Shalom's empty comments. During all the years of high interest rates, the Ministry of Finance staff argued that the major damage done by the interest rates was not in expensive interest, but in the shekel revaluation that hurt business sector profitability. Does anyone still think the shekel is over inflated after 15% devaluation in six months?

And short term interest, the rate Bank of Israel sets, has been at a low for several months. And those responsible for effective long term interest sit in the Ministry of Finance that has inflated the budget deficit.

Most importantly, the damage from inflation and rapid shekel devaluation is far greater than any possible damage to the business sector from expensive short term interest. Now is not the time to wait, to talk, to examine and to pray ¿ now is the time to act.