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| 4.6.2008 |
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Address by the Governor of the Bank of Israel, Professor Stanley Fischer, to the Annual Conference of the Israel Economic Association
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| Over the past year, the more advanced and sophisticated economies have had to deal with a major financial crisis with wide-ranging consequences. By contrast, the emerging market economies have succeeded in maintaining financial stability. |
| Research attempting to understand the reasons for the crisis is well under way, and recommendations for changes in supervisory regulations and systems have started to appear. These include the important report of the Financial Stability Forum entitled "Enhancing Market and Institutional Resilience." However, I do not intend to speak today about supervisory systems, but rather about central banks’ interest rate policies in the circumstances currently prevailing in the global economy––and I will of course focus on Israel’s economy. |
| After over four years of rapid global growth, nearly all economies have had to deal with the implications of today's reality––declines in stock exchanges, increases in risk premiums, adverse effects on banks in several countries resulting from the financial crisis, the weakness of the dollar against most currencies, and the increase in inflationary pressures deriving from the rise in world oil and food prices in 2007 and 2008. Israel’s economy faces the same reality. |
| In almost all countries the central bank is in the forefront of the efforts to deal with the special situation prevailing since July–August 2007. That is the case in the US, the eurozone, the UK, Latin America, and Asia, and that is the case in Israel too. |
| The financial crisis and the crisis on the real side are particularly severe in the US, where the Federal Reserve has reacted by drastically cutting its interest rate. In the eurozone and the UK too the central banks have had to be very creative to handle the liquidity shortage caused by the crisis, and to deal with the slowdown expected to come in its wake. At present, with inflation at a relatively high level in the US, the eurozone and the UK, the central banks have had to shift attention to that issue. |
| Does that means that the aims of the central banks changed? Has the inflation target become less important as the central objective of monetary policy? Similar questions have been raised with regard to the Bank of Israel. |
| The new Bank of Israel Law, on which the Bank is working in full cooperation with the Ministry of Finance and with the support of the Prime Minister, defines the Bank’s objectives. Thus, the new law specifies that the main objective of the Bank is to maintain price stability and at the same time, provided that its main objective will not be compromised, to support the attainment of the other objectives of the government’s economic policy, in particular the encouragement of employment and growth. That is the accepted formulation in the laws governing central banks in the advanced economies that amended their central bank laws in the last twenty years, for example, those relating to the ECB and the Bank of England. In addition, the third overall objective of monetary policy in the draft of the new Bank of Israel Law is to support financial stability. |
| I will explain the recent Bank of Israel interest rate decisions in the light of these objectives: |
| In November and December 2007 prices of imports increased, mainly due to the rise in world food and energy prices. Instead of increasing the interest rate steeply to return inflation quickly to the target range, the Bank decided to raise interest gradually in the expectation that this policy would help to bring inflation back to the target range within the next twelve months. Thus, the interest rate was raised by 25 basis points in January. |
| However, against the background of the deterioration in the US economy at the end of 2007 and the beginning of 2008, when the assessment that Israel’s economic growth was likely to slow in 2008 became firmer, the Bank of Israel considered that there was room for a relatively sharp reduction in the interest rate, partly to support real activity, and mainly in light of the assessment that the disinflationary effect both of the expected global slowdown in 2008, particularly its expected effects on oil and food prices, and of the cumulative strengthening of the shekel would help to bring inflation back into the target range by the end of the year. |
| Thus the Bank cut the interest rates for March and April by half a percentage point each. In the press releases announcing these decisions the Bank stated, “Subject to the reduction in inflationary pressures, as described above, and taking into consideration the Bank of Israel’s assessments that inflation will return to within the target range this year, the 0.5 percentage point cut in the interest rate is likely to support continued economic growth and employment.” |
| When it came to the interest rate decision for May, in the face of indications of a surge in inflation the Bank decided not to change interest rate, and explained, “The decision to keep the interest rate unchanged for May is consistent with support for growth and employment, subject to inflation returning to the price stability range.” |
| Finally, in light of the relatively wide deviation from the inflation target in April, the Bank raised the interest rate for June by 25 basis points, noting, “This increase in the interest rate is required to return inflation to the price stability target range of 1–3 percent inflation a year, and thereby to provide the basis that is essential for sustained growth.” |
| In light of the Bank of Israel’s explanations, we may summarize by saying that in its decisions on the interest rate the Bank took into account the expected slowdown in real activity, assessing that inflation would return to the target range within a reasonable period. In other words, the Bank consistently applied its flexible inflation targeting approach. |
| What is the significance of this approach? The Bank considers the inflation target to be the major objective of its interest rate policy. That said, it is flexible in that it does not think it necessary to react to every deviation from the target with actions aimed at bringing inflation back to the target immediately, but rather to use measured steps that will do so gradually, within a reasonable time, up to twelve months––hence the increases of 25 basis points in the January and June rates. |
| This approach to the interest rate policy––which takes into account all the objectives specified in the new Bank of Israel Law, i.e., flexible inflation targeting––is the approach followed by the Bank. It is important to stress, however, that maintaining price stability is the Bank’s central goal, and in any case of conflicting targets, price stability takes priority. This is in accordance with the new Bank of Israel Law. |
| We hope that we will soon complete the joint drafting of the law and that it will be placed before the Knesset. That will constitute an important achievement for the State of Israel. |
| A word in conclusion: recently voices have been heard calling for the Ministry of Finance to take steps to influence the exchange rate or modify the implications of the strengthening of the shekel. There is no miracle cure for this, and we must avoid measures which seem to provide solutions in the short term, but do not help, or even cause more harm, in the long term. I think that the Ministry of Finance is following the right policy at this time, the policy of steadfastly preserving fiscal discipline. That provides the most important infrastructure for successfully supporting the real objective of Israel’s economic policy––rapid and sustained economic growth and continued increased employment. For its part, the Bank of Israel will continue to contribute to this important task by returning inflation to the price stability target range. |
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