Two main conclusions can be drawn from the Bank of Israel statement that accompanied yesterday's 75-basis point interest rate cut. The first is that Israel's interest rate will continue to fall over the coming months. The second is the increased chances of a confrontation between the Bank of Israel and the commercial banks.
Yesterday's press release by the Bank of Israel was formulaic, reiterating the statements in previous announcements since it began to actively use the interest rate to fight the recession. The Bank of Israel mentioned the decline in activity in the real economy, the worsening global recession, the falling inflation rate, and the interest rate cuts worldwide to unprecedented levels. Taken together, the reasons lead to two conclusions. One is that all the arguments favoring a steep interest rate cut are these, and they can only be expected to increase in the coming weeks and months. Hence the feeling that yesterday's rate cut is not the end of the story, and that Israel's interest rate can still go down.
The question is whether the policy of interest rate cuts is effective in battling the recession. For an effective response, two basic conditions must be met: the financial system, especially the banking system, must translate the expansionist monetary policy into an expansionist credit policy; and the government's fiscal policy must undertake the responsibility for generating economic activity during the slump. Both these conditions are currently absent in Israel, rendering the effectiveness of the Bank of Israel's policy quite limited.
This, in effect, is the foundation for the second conclusion implied in the Bank of Israel's announcement. The penultimate sentence of the press release states, "The current reduction in the interest rate is intended to help cut the cost of credit and to strengthen the economy’s ability to handle the slowdown in economic activity and the implications of the global economic crisis."
A free understanding of this sentence gives the following explanation: the Bank of Israel has tried to help the banks by changing the liquidity structure, per last week's announcement. The measures are intended to narrow the interest spreads at the commercial banks. This time, the Bank of Israel is also significantly reducing the interest rate, in an effort to lower the cost of financing for the business sector. If the bankers don’t get the hint, they should reread Governor of the Bank of Israel Prof. Stanley Fischer's speech at the Association of Banks in Israel's annual meeting.
Anyone who does not want government intervention in the banks' interest margins had better remember the reasons for this year's reform in bank fees. Fischer can invite all of Israel's bankers to his office and explain the facts of life to them. While, officially, the Bank of Israel has no authority to dictate the banks' own interest rates, in practice, the governor can warn the bankers, even more explicitly, about tense relations with the central bank.
A banker who fails to get the message should bear in mind what will happen when the Knesset reconvenes after the elections, and when the veteran and new MKs will compete over who is the greater enemy of the banks. A banker who does not want such complications should begin to toe the Bank of Israel's line, change its policies, and decide in advance what they can do to placate the Bank of Israel, and what they cannot do.
Meanwhile, it ought to be borne in mind that the second condition for securing the success of the monetary policy - an effective fiscal policy - does not exist, and is unlikely to exist for at least another three months or so. This will only enhance the urgency and importance that Fischer and his officials impart to the banks' reducing the cost of money to the business sector. Moreover, so long as the fighting in the south persists, the need for aid to the business sector will grow, especially for companies that have been paralyzed. The tough terms for extending credit and a rise in the cost of money will not be measures that the Bank of Israel can permit under these conditions.
Published by Globes [online], Israel business news - www.globes-online.com - on December 30, 2008
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