There is no real surprise in the Bank of Israel's decision to cut the interest rate by 0.25%. As expected, the bank's press release spelled out all the elements of the decision, especially the drop in inflationary expectations and the economic slowdown. The question now is whether the bank will have to cut the interest rate again, particularly in the fourth quarter of the year.
What we already know is that the third quarter of the year will show a sharp drop in economic activity, lower consumption, the collapse of internal and external tourism, another decline in industrial output, and also a decrease in exports of goods. The longer the fighting lasts, the worse these problems will get.
In the past, there were cases in which the economy quickly recovered from war-caused damage, for example following the Second Lebanon war, which began in the summer of 2006. That recovery, however, which surprised the Bank of Israel and the Ministry of Finance, occurred at a time of a boom in the global markets, expanding world trade, and noticeable growth in consumption. It is doubtful whether these conditions will repeat themselves in the coming months, meaning that the slowdown is liable to persist into the fourth quarter of the year.
If the Bank of Israel believes that the economy needs a bigger stimulus, cutting the interest rate to 0.25% will be on the agenda. It is reasonable to assume that the bank will assess macroeconomic developments after a ceasefire is achieved. The only question is how long that assessment will take.
Limited Effectiveness
To tell the truth, in the currently prevailing conditions, lowering the interest rate to 0.5% appears of limited effectiveness. The shekel exchange rate barely responded, and it is questionable whether it will motivate households to bolster their demand in a state of "routine emergency." The Bank of Israel can only hope that cutting the interest rate in the short term will affect the cost of resources in the medium and long term, and help the banks decide to continue expanding their credit to the business sector, especially small and medium-sized businesses.
In view of these constraints on monetary policy, it can be stated that a great deal of what happens in the economy will depend not only on the bank itself, but also on how the Ministry of Finance responds to significantly lower growth. When the interest rate is very low, fiscal policy will bear special responsibility for sparking activity - whether by expediting infrastructure projects, or by formulating appropriate compensation mechanisms for small and medium-size businesses affected by the fighting and finding arrangements that will help self-employed people with small and medium-sized turnovers, even if this exacerbates the expected drop in tax revenues caused by the economic slowdown.
If the Ministry of Finance decides to meet the deficit target, or to deviate from it only marginally, a real problem will be created, because it will cause additional cuts in civilian spending. Keep in mind that the Ministry of Finance will come under considerable pressure to supplement the defense budget, and the temptation to respond with cuts in other items is liable to be considerable. The government ministers could help Ministry of Finance officials achieve this task through an assessment of priorities, but it is doubtful whether this will occur. Judging by past experience, the Ministry of Finance budgets department will prefer to minimize risks through a budget trimming plan, even at the price of lower growth.
Such behavior will only saddle the Bank of Israel with an additional burden and confront Governor Karnit Flug with a real dilemma: whether to cut the interest rate to zero. If this happens, Israel is liable to encounter problems somewhat reminiscent of other countries coping with a negligible interest rate, currency appreciation, and strong fiscal pressures. In this case, the Bank of Israel may have no choice other than to increase its intervention in the foreign currency market. For now, this is only a scenario, but its materialization may come closer as the economy slows down.
Published by Globes [online], Israel business news - www.globes-online.com - on July 29, 2014
© Copyright of Globes Publisher Itonut (1983) Ltd. 2014