The Bank of Israel today published the minutes of interest rate decision for March. On February 23, Governor of the Bank of Israel Prof. Stanley Fischer cut the interest rate by 25 basis points to an all-time low of 0.75%. Many analysts had expected a larger cut.
The minutes indicate most of the Bank of Israel's five-member limited monetary forum supported Fischer's decision. Four members recommended a 25-basis point cut and one member recommended a 50-basis point interest rate cut.
The argument for limiting the interest rate cut to 25 basis points was that previous rate cuts were not translated into lower interest rates by the banks.
Bank of Israel officials now note that a liquidity trap has developed. The minutes state, "Despite the fact that the Bank of Israel's interest rate is still positive, the interest the banks pay depositors is close to zero, and they have little room to reduce it further. In this situation, in order to preserve the interest rate spread (also known as banking spread), the transmission mechanism from a reduction in the Bank of Israel interest rate and the rate charged to borrowers is weakened.
"In these circumstances, there could be a switch from time deposits to current-account deposits, which would make it more difficult for banks to manage liquidity and to balance deposits and loans to different terms. The public may also switch from bank deposits into other assets that could create an undesirable increase in risk for savers in the financial system."
This situation is known as a liquidity trap. The public essentially receives low or no yield on deposits. Therefore, on purely rational calculations, the public decides that it is better to keep its money liquid, i.e. in checking or savings accounts.
In his speech to the Bank of Israel's Information and Statistics Department two weeks ago, Fischer explicitly declared, "We're not in a liquidity trap." It is now clear that some of his colleagues think otherwise. Bank of Israel officials are also worried that given the near zero return on deposits, the public may be tempted to invest in high-risk investments.
Published by Globes [online], Israel business news - www.globes-online.com - on March 9, 2009
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