A third of the immediate effect on the shekel exchange rate of the Bank of Israel's interest rate cut has faded in recent days, and if this trend continues, the entire effect will be jeopardized. That is the conclusion arising from an analysis of the effective exchange rate index published by the Bank of Israel, The tools available to the Bank of Israel to halt the trend are a further interest rate cut, which will probably have little effect, and setting a floor for the shekel exchange rate, with all the risks of such a measure.
Few other than the Bank of Israel and foreign currency traders are familiar with the effective exchange rate index, but anyone who has followed the exchange rate of the dollar or the euro up until now would do well to study this dull and complicated index, which has become an unofficial compass for a Bank of Israel interest rate policy aimed at maintaining export competitiveness, while paying less attention to developments in real estate and bond prices.
The Bank of Israel believes that the effective exchange rate index is the best reflection of the foreign currency market's effect on the Israeli economy. It is true that we all following the shekel exchange rates against the dollar and the euro, but Israel trades with many other countries around the world. Take exports of peppers to Russia, for example, which is affected by the ruble-dollar exchange rate, as well as the shekel-dollar rate. Israel's exports to Russia will suffer if the ruble weakens more than the shekel against the dollar.
In order to construct the effective exchange rate index, the Bank of Israel took Israel's 38 leading trading partners. The currency of each country is given a weight in the basket equal to that country's relative share of Israel's trade, as of January 1, 2009.
Since trade with the US accounted for a quarter of all of Israel's trade at that date, the dollar is given a 25% weight in the index. The euro's weight in the index is greater than that of the dollar, because it is the currency of most of Israel's trading partners.
Nearing the red line
The red line of the effective exchange rate index was set on August 1 - the date on which the Bank of Israel began its most recent interest rate cuts - when its value was 80.1. From the Bank of Israel's perspective, the two interest rate cuts that brought the interest rate from 0.75% to 0.25% served their purpose until December, when the index set a record of 88.4. The Bank of Israel attributed the recovery in exports to the shekel's weakness against the currencies in the index. Since December 3, however, the index has fallen rapidly, and threatens to drop to its level in August.
This retreat was ignored by the public, the commentators, and the media, who continued to follow the shekel's weakening against the dollar, and mistakenly thought that the Bank of Israel had no reason to continue cutting the interest rate. The Bank of Israel monetary committee, however, thought otherwise, and decided to take action on February 23, when the index reached 81.48, in other words, less than 2% away from the August red line from which the entire process began. The most recent interest rate cut sent the index back up to 84 at the beginning of the month, but the index began to slip again in recent days, and is threatening to return to the new red line of February 23.
It may be premature to say that the Bank of Israel's most recent interest rate cut has failed to achieve its objectives. The first interest rate cut started having an effect only two weeks after the decision itself, but it is clear that the situation today is completely different from what it was in the summer. This time, the shekel is trapped between the Scylla of the shekel's weakness against the dollar and the Charybdis of the shekel's strength against the euro.
What effect can a further 0.1% cut in the Bank of Israel interest rate have on the global storm sweeping over the foreign currency market? The Bank of Israel has a more effective way of influencing the exchange rate: setting a floor for the shekel exchange rate, similar to the floor that was recently abolished in Switzerland after three years. In the opinion of economists, the Swiss experience shows that the exchange rate floor tools can succeed as long as it is used, but exiting it exacts a steep price, mainly in the central bank's international credibility. At present, it appears that the floor is not an option for the Bank of Israel, but everything depends on the question of how the effective exchange rate index behaves from now on.
Published by Globes [online], Israel business news - www.globes-online.com - on March 12, 2015
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