On the brink of recession: Israel's central bank has a tough decision to make on quantitative easing

Published October 26th, 2014 - 12:40 GMT

The Bank of Israel and its governor, Dr. Karnit Flug, are very close to a decision to returning to quantitative easing as a replacement for cutting the interest rate. The Bank of Israel Monetary Committee will have to decide next week whether to return to the government bond market as a purchaser, or to take other extraordinary measures. A look at the data facing Flug and the committee makes it clear that the Monetary Committee has a great deal of important work to do, and it is very doubtful whether cutting the interest rate by another 0.25%, which would put it at zero, can provide a solution to the economy's needs at this juncture

There are two closely linked questions facing the governor and the committee. First of all, the economy is on the brink of recession, with annual growth having difficulty rising above 2%. Secondly, we are in deflation, at least according to the Consumer Price Index and inflation expectations, as measured in the capital market. The annual inflation rate is at minus 0.3%, far from the official 1-3% target range. Inflation expectations are behaving accordingly, dropping over the past six months by 0.5% to 1% for the coming year.

The direct significant of these figures is that the real interest rate in the economy and real returns in the bond market have not declined in recent months, despite the drop in the nominal interest rate. Furthermore, despite the accelerating devaluation of the shekel, inflation expectations in the bond market continue to fall, meaning that the market still does not believe that a structural change has occurred, and expects the shekel-dollar exchange rate to go back down. Keep in mind that the steep falls in inputs and commodities prices around the world are offsetting a lot of the devaluation's effect on prices in the market.

In the absence of any real fiscal policy, the Bank of Israel is being forced to bear the brunt alone, and given the emerging situation, to which the detriorating position of businesses in southern Israel should be added, the only way it can act is to use non-conventional tools. The last time the bank adopted a policy of quantitative easing was in 2009, due to fear that the global economic crisis would upset the local economy. When that did not occur, the bank decided in August 2009 to halt it bond purchases.

This time, Flug is being forced to ask herself whether the time has come to return to the government bond market in an attempt to encourage economic activity. She included hints of this in her comments in interviews in recent weeks, most recently with Reuters when she was attending the annual conference of the International Monetary Fund.

Two factors could deter the governor and the bank from taking unusual steps such as quantitative easing. The first is any sign that, despite the current economic figures, growth is indeed showing signs of speeding up to 3%, the official forecast for 2015. The second is signs of a rise in inflation expectations in the capital market, which seems unlikely at the moment. In any case the proposals for action in the bond market, or other equivalent measures, are on the table, and the Monetary Committee members, and Flug herself, will have to make a decision next week.


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