Bank of Israel Governor Surprises Market by Keeping Interest Where it Is

A year into his tenure as the governor of the Bank of Israel, economist Amir Yaron is proving himself an able and careful strategist. His Monday decision to maintain Israel's benchmark interest rate at 0.25% and not cut it to 0.1% demonstrates that he understands the complexity of Israel’s financial status, and the sparsity of the tools at his disposal.

The majority of analysts, 58%, according to a Bloomberg survey, expected Yaron to lower the interest rate, which was raised for the first time in seven and a half years in November 2018 under temporary Governor Nadine Baudot-Trajtenberg. But Yaron and the bank's monetary committee decided to play the waiting game. While Yaron has stated two months ago that a negative interest rate is also an option he is willing to consider, he knows that it is a dangerous tool that has yet to be tested in Israel, and that its consequences are hard to predict.

Amir Yaron. Photo: Amit Sha'al

Since Yaron’s decision went against most analysts’ forecasts, it led the shekel to appreciate against most major currencies. To counterbalance that effect, Yaron announced a significant purchase of dollars. While a signal that he still has other tools under his belt, the decision to intervene in the foreign exchange market has led to some local criticism.

Yaron's policy reflects his perception of a dynamic exchange rate window, not a set target or minimal exchange rate but a range that changes according to economic and political events both in Israel and globally. On Monday, he has decided the exchange rate strayed from that window and intervened, but that does not mean the same dollar-shekel exchange rate will draw such an intervention in the future.

Regarding inflation, the bank knows the data well. Annual inflation reached 0.4% in October, strides below the lower limit of the government's price stability target of 1%-3%. Core inflation dropped sharply in recent months from around 1% to 0.5%. But according to the bank, one-year inflation expectations remained stable near the lower limit. In other words, the bank sees the current inflation drop as temporary.

The bank seems unconcerned by the declining growth rate of Israel's gross domestic product (GDP), which increased at an annual rate of 4.1% in the third quarter of 2019, but according to its announcement, the bank is worried about the potential effects of Israel's continuous political instability. While the economy is growing at a rate close to its potential, should the political uncertainty continue and the interim government be forced to operate on a continuance budget for a prolonged period, the bank cautioned it could have a contractionary effect. The bank is slightly more optimistic regarding future consumer expenditure, export, and investments, as well as the global economy.

Yaron is well aware that his policy is limited by the world’s two leading central banks, the American Federal Reserve and the European Central Bank. According to the Bank of Israel's announcement, "it appears that the process of deepening monetary accommodation by the major central banks has reached its limit at this stage."

Though he has maintained the current interest rate, Yaron has emphasized that "it will be necessary to leave the interest rate at its current level for a prolonged period or to reduce it in order to support a process at the end of which inflation will stabilize around the midpoint of the target range, and so that the economy will continue to grow strongly."

In other words, the bank's current policy is already quite broad, and it is unclear how a 0.15% cut to the interest rate could really affect inflation or support growth. Most of the bank's senior executives are of the opinion that such a cut will not really help those two objectives, but that it will result in an unsavory byproduct: pushing the valuations of real estate and securities upwards. As governor, Yaron does not want to sign off on a decision that creates a bubble ready to burst, should the many potential risk factors come into effect.