The Bank of Israel uses the tools available to it to achieve the targets specified in the Bank of Israel Law: price stability as its prime objective; support for the government's economic targets, in particular growth, employment, and the narrowing of social gaps, provided that these actions do not prevent it from achieving price stability over time; and support for the stability and orderly functioning of the financial system. Clearly the latter objective has been the focus of special attention recently, in the context of lessons learned form the latest global crisis.
The challenge facing the Bank of Israel in achieving its targets in the current conditions is to maintain price stability, i.e., to keep annual inflation within the 1–3 percent range defined by the government as the range of price stability, to support growth and employment in light of the low growth rates in the advanced economies which serve to hold back the demand for Israel's exports, and to support financial stability by means of measures that will prevent the creation of distortions in the pricing of assets, including housing prices. To achieve these various objectives the Bank of Israel employs the range of tools in its arsenal––the rate of interest, intervention in the foreign currency market, and macroprudential activities, i.e., tools that relate essentially to the rate of increase, the composition, and the terms of credit in the economy.
The challenge facing the Bank of Israel in achieving its targets in the current conditions is to maintain price stability, i.e., to keep annual inflation within the 1–3 percent range defined by the government as the range of price stability, to support growth and employment in light of the low growth rates in the advanced economies which serve to hold back the demand for Israel's exports, and to support financial stability by means of measures that will prevent the creation of distortions in the pricing of assets, including housing prices. To achieve these various objectives the Bank of Israel employs the range of tools in its arsenal––the rate of interest, intervention in the foreign currency market, and macroprudential activities, i.e., tools that relate essentially to the rate of increase, the composition, and the terms of credit in the economy.
Israel's economy, similar to some of the emerging market and advanced economies, started to recover from the global crisis relatively soon, as was reflected by rates of growth and the decline in unemployment from the middle of 2009. The increase in inflation and inflation expectations one and two years forward obliged the Bank of Israel to start increasing the interest rate gradually in order to maintain price stability. In contrast, the US economy and a significant number of European economies are growing very slowly, with no real decline in unemployment, and this is reflected in a low inflation rate and a fragile situation in the financial sector. This necessitates a continuation of the highly expansionary monetary policies of the central banks in those countries, i.e., an interest rate close to zero, and even a return to quantitative easing measures––the purchase of assets such as government bonds and other financial assets on the secondary market.
The rate of increase of the interest rate depends on the inflation environment (actual and expected inflation), on the rate of growth in Israel and abroad, on the rate of increase of the interest rate by the leading central banks, and on developments in the shekel exchange rate. With regard to the exchange rate, the Bank closely monitors the effective exchange rate , i.e., the average shekel exchange rate against a basket of the currencies of Israel's trading partners weighted by the amount of trade with them. A higher inflation environment, faster growth in Israel and abroad, and less uncertainty about continued growth are factors that have an upward effect on the interest rate. The differential between the Bank of Israel's interest rate and those of the major central banks, and the trend of appreciation in the effective exchange rate act in the opposite direction, moderating interest rate hikes.
As a result of the differences in the rates of recovery from the crisis in different countries, and hence in the extent of monetary expansion required, differentials between interest rates are created which encourage short-run capital flows that may lead to the over-strengthening of the shekel. This is likely to have an adverse impact on the profitability of exports, and thus also on the activity of the exporting sector and the economy as a whole. The combined use of both policy instruments, i.e., the interest rate and intervention on the foreign currency market, acts to achieve both targets––the maintenance of price stability and the support of activity, by moderating the effect of the increase in the interest rate on the exchange rate.
The Bank of Israel does not normally try to fix the exchange rate or to influence global exchange rate trends. By intervening in the foreign currency market, however, the Bank acts to moderate the effect of short-term capital flows that result partly from interest rate differentials and that cause changes in the exchange rate. A study carried out in the Bank of Israel into the effect on the exchange rate of the Bank's intervention in the foreign currency market found that its initial foreign currency purchases in March 2008, the increased scale of the purchases from July 2008, and the transition from fixed daily purchases to intervention according to market conditions in August 2009 resulted in a significantly depreciated shekel exchange rate relative to what it would have been were it not for the intervention. This action served to minimize the negative effect of the global crisis on Israel's economy.
When the Bank of Israel decides on its policy regarding interest rate changes and foreign currency purchases, it takes into account its benefits and potential costs. It is important point to note, however, that the benefit is not measured only in financial terms: by law the Bank is not a profit-seeking institution. The Bank acts to achieve the goals set by the Law: price stability, the support of the objectives of economic policy, such as growth, employment and the narrowing of gaps, and the support of financial stability.
In financial terms, central banks' policies sometimes bear a cost, and sometimes they yield a profit. If there is a cost, it should be weighed against the benefit: when the Bank of Israel avoids excess appreciation of the shekel, or prevents abnormal volatility of the exchange rate, it is contributing to the success of the whole economy, to economic growth, and to increased employment. When the Bank holds the appropriate level of foreign exchange reserves, the whole economy reaps the benefit of economic strength, enhanced financial stability, protection against unexpected events, and reduced vulnerability to various crises.
In financial terms, central banks' policies sometimes bear a cost, and sometimes they yield a profit. If there is a cost, it should be weighed against the benefit: when the Bank of Israel avoids excess appreciation of the shekel, or prevents abnormal volatility of the exchange rate, it is contributing to the success of the whole economy, to economic growth, and to increased employment. When the Bank holds the appropriate level of foreign exchange reserves, the whole economy reaps the benefit of economic strength, enhanced financial stability, protection against unexpected events, and reduced vulnerability to various crises.
Recently many countries have intervened in their foreign currency markets by purchasing foreign currency: Australia, Brazil, China (which continues with the intervention it has engaged in for a long time), Colombia, Mexico, Russia, South Korea, Switzerland, and most recently, Japan, all these are buying foreign currency. Some of them, and others including Peru and Thailand, have announced the introduction of taxes and other limitations on the import of capital from foreign investors, alongside an easing of the rules of investing abroad.
House prices have increased rapidly in the last two years, partially due to the low rate of interest, after a decade in which they declined relative to the average wage and relative to the CPI. Thus, the current level of house prices does not deviate significantly from the economic fundamentals of the housing market, but continued rapid price increases could threaten stability, and in that sense could lead to the creation of a bubble. Against this background, and in light of the slow reaction of supply to the increase in demand for housing (i.e., the rate of building new houses is lagging behind the rate of population growth), and since the Bank of Israel interest rate is appropriate to the current macroeconomic situation (as explained above), the Bank recently adopted a policy to moderate housing demand by introducing macroprudential measures. It did so by means of directives issued by the Supervisor of Banks intended to increase the cost of large floating-interest-rate mortgages with high leverage (i.e., with high loan-to-value ratios). These steps are intended, among other things, to cool the demand for housing until the supply of houses increases significantly.
The Bank of Israel has a variety of instruments for the injection of liquidity into the financial system, including daily loan and deposit tenders and money market instruments, such as makam and repo.
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