PresentationI am pleased to open this Conference marking 60 years since the establishment of the Bank of Israel. We are holding this conference following a decade during which the Bank of Israel Law was changed, entrenching the Bank’s independence, its policy objectives and decision-making processes, similar to legislation regarding the leading central banks. This was also the decade in which we maintained and bolstered the price stability that had been attained previously—and so it is natural that this subject would be the focus of this conference.
Those who have experienced inflation of more than 450 percent can appreciate the considerable advantages that price stability provides to the economy and citizens, as it affords certainty to investors, consumers, workers, and employers, and it prevents the need to invest massive resources in maintaining the value of financial assets. In this decade we also, in contrast to most advanced economies, successfully made it through the financial crisis that began in 2007 and that essentially stayed with us for most of the decade.
The development of the Bank’s functions since it was established reflects the development of Israel’s economy, the global economy, the way that the Israeli economy is integrated into the world economy, as well as the development of theory and practice of money policy conduct worldwide.
It is important to note at this event marking 60 years of the Bank of Israel, the range of important functions performed by the Bank through its various departments: whether it is the Currency Department, which is responsible for regular supply of banknotes and coins to the economy, and in this framework will launch the new 200 shekel banknote in the coming days; the Market Operations Department, which puts the monetary policy into practice and manages the foreign exchange reserves that are the Israeli economy’s insurance policy; the Banking Supervision Department, which ensures that that public’s money deposited at banks is in safe hands and that the banks treat their customers fairly; the Accounting, Payment and Settlement Systems Department, which ensures that, for example, a check that we deposit or a funds transfer that we carry out always reach their intended recipient; or whether it is the Research Department whose analyses and policy recommendations attempt to provide a response to urgent policy questions and to the Israeli economy’s long term issues. All these—supported by the Information and Statistics Department, the Information Technology Department, the Human Resources and Administration Department, and various administrative units that provide the infrastructure in terms of technology, data, and people—enable the Bank to carry out its numerous objectives.
The first part of the Conference will deal with the history of money policy in Israel (Dr. Arie Krampf) and a deep analysis of the monetary developments in Israel over the past decade (former Monetary Committee members Prof. Alex Cukierman and Prof. Rafi Melnick). In my remarks, I would like to focus on the Bank of Israel’s monetary policy since the global financial crisis, its achievements and challenges, including those facing us today.
The price paid by the Israeli economy for high inflation, and the advantages of price stability from which the economy has benefitted, are addressed by Professors Alex Cukierman and Rafi Melnick, in the paper they will present here today. These advantages include, among others, the fact that monetary policy is more effective when inflation expectations are well anchored, because then the changes in the interest rate that are required to achieve the inflation target are more moderate, and therefore the return to the target will bear a lower price in terms of growth and unemployment.
Since we attained price stability in Israel, and the inflation target has been set for the range of 1 to 3 percent, the price-stability anchor has been maintained, despite periods, which were not short, in which actual inflation was outside the target range (Slide 2): Throughout the period, confidence in meeting the inflation target was reflected in medium and long term inflation expectations being within the target range, near the midpoint.
The flexible monetary policy—being ahead of the curve—led by the Bank of Israel during the global financial crisis, helped the economy to get through the crisis period with only a moderate slowdown, and an increase in unemployment for only a short period of time; GDP and employment returned to growth after two quarters, and this despite a global economic environment in which the recovery arrived only later.
The financial system as well, particularly the banking system, which was supervised tightly and managed cautiously, maintained stability during the crisis. Thus it avoided the need to allocate numerous resources to dealing with failures—of the type that many countries experienced during the crisis, and in the wake of which need to deal, still today, with the consequences reflected in, among other things, heavy debt.
It is clear that we have been facing new challenges to monetary policy since the crisis, and these make the decisions complicated. Policy that is focused on achieving the objectives set in law—maintaining price stability, support for activity and employment, and support for financial stability—requires the use of a range of policy instruments that are available to the Bank. While in the past, under different conditions, the substitution created by the policy was between support for activity and support for price stability (such as during a period of a negative supply shock), the substitution we have faced for most of the post-crisis period has been between support for activity and stability, and considerations of financial stability.
What factors are the main considerations when formulating policy?
1. A moderate global environment—in particular, a marked slowdown in world trade growth, reflected in a slowdown in global demand for Israeli exports.
2. Appreciation, against the background of prolonged appreciation in the Current Account, which was strengthened by highly accommodative policy of major central banks, including zero interest rates and marked volumes of quantitative easing. Since the middle of 2013, the forces for appreciation have become stronger due to the start of production of natural gas, which reduced fuel import volumes, and the Bank of Israel began to offset these forces by additional purchases of foreign exchange. The appreciation weighs on the activity of the tradable sector, especially against the background of moderate global activity, reflected in a slowdown in global demand for Israeli exports. In terms of the appreciation’s effect on inflation, despite current estimations that indicate that the transmission from the exchange rate to prices is very low, the extended and cumulative effect of the appreciation on inflation cannot be ignored.
3. Declines in prices of oil and commodities. These are reflected in price declines in the tradable component of the CPI, and have contributed to undershooting the target since June 2014, similar to what has occurred in many OECD countries. With that, it is important to emphasize at this point that in Israel, inflation expectations for slightly longer terms—in which these effects (together with the impacts of Value-Added Tax reductions, cancellation of the television fee, and reductions in electricity and water prices) will be exhausted—remain entrenched around the midpoint of the target range.
The combination of low inflation, against the background of commodity price declines worldwide and exchange rate appreciation, and the negative output gap (that is, GDP that is lower than potential GDP) (Slide 3), in view of moderate demand from abroad, required the Bank of Israel to adopt accommodative monetary policy, which was seen in the reduction of the interest rate between October 2011 and September 2015 from 3.25 percent to 0.1 percent. An additional component in the monetary expansion is foreign currency purchases, which were intended to moderate the appreciation and the negative impact on the tradable sector.
The accommodative monetary policy helped support private consumption, which takes on added importance in view of the effect of the global slowdown on exports, and enabled the economy to continue to grow at a rate of 2.5–3 percent, and supported a decline in the unemployment rate alongside an increase in the participation rate.
It should be noted that the price declines derive from decreases in prices of raw materials around the world, which is an improvement in Israel’s terms of trade as an importer of raw materials. This raises the question of to what extent monetary policy should offset price declines derived from that. To the extent that we are talking about a one-off change in price levels, and to the extent that it does not have longer-term effects on inflation expectations, Bank of Israel policy does not attempt to offset these effects on price levels.
Forward guidance and unconventional tools: Until recently, the Bank of Israel avoided using forward guidance, among other reasons because in a small and open economy it is very difficult to forecast the factors that will affect policy in the future. Recently, in view of the expectation for continued moderate activity in the global economy, and with it, moderate demand for Israeli exports, the Monetary Committee was able to assess with a relatively high degree of certainty that the interest rate will remain low for a considerable period of time, and this assessment was noted in the monetary policy notice for November.
In regard to additional, “unconventional” policy tools used by central banks to provide additional easing when the interest rate reaches near-zero levels, the Bank of Israel noted that they are included in the tools available to it, and they could be used if and when the Committee assesses that conditions are extraordinary and justify such use.
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One of the side effects of accommodative monetary policy, which is required to support the return of the inflation rate to within the target range and to support employment, is the increase of asset prices, including home prices. As in other countries in a similar situation, one of the expressions of low interest rates and yields (for short and long terms) is investors searching for yield, which for us is reflected in an increase in demand for real estate. (Slide 4, Home prices and mortgage volumes)
Against this background, we have seen a marked increase in housing demand, and in mortgage volumes. The response by supply was delayed (we saw an increase in building starts to a level above 40,000 housing units only about 3 years after home prices began to increase in 2007, and an increase in building completions only 6 years after home prices began increasing), and this led to a prolonged increase in home prices. The increase in mortgage volumes required the Bank of Israel to respond with a series of measures in order to limit the risk inherent in them. The macroprudential steps helped to moderate the risk of an adverse impact on households’ repayment ability, and the increase in stock of homes, which as noted was delayed, should lead to a halt in the price increases.
Interim conclusion—In the complex conditions in which we worked in recent years, and in order to strive toward achieving the policy’s various targets, we had to utilize the policy tools available to us—the interest rate, foreign-exchange-market intervention, and macroprudential tools, at various dosages. This was in order to strengthen some of the transmission mechanisms of policy, while counteracting or weakening others (for example, weakening the effect of the short-term interest rate on the mortgage market by placing a limitation on the variable-rate component of the mortgage) (Slide 5).
Looking ahead, the challenge we will deal with in the near term is related to the divergence in direction of policy of the blocs, as the US is expected to begin a process of raising the federal funds rate, while the ECB is enhancing its monetary expansion. Managing policy under such conditions in Israel, which is between the two blocs, will require taking into account the range of effects from developments in major economies, including the effects on exchange rates, on activity, and on financial markets. Against the background of the sharp changes in the exchange rate of the euro against the dollar—those that have occurred and those that are likely to occur given the policy expected in both blocs, we will have to consider questions such as: Is the Effective Exchange Rate, which represents the effect of a range of exchange rates on foreign trade and real activity, also the one that is relevant for examining capital flows and the conduct of participants in various markets? What should the policy response be given such developments? These are among the issues that we are already considering, and that will of course require enhanced review and discussion.
And in conclusion - The period following the global financial crisis has continued to pose many policy dilemmas with which central banks, including the Bank of Israel, must deal when conducting policy: what weight to give the exchange rate in conducting policy, and what is the relevant exchange rate? What is the appropriate weight to assign to financial stability considerations, and to what extent can macroprudential steps replace or complement interest rate policy? To what extent should policy respond to transitory deviations from the target, and how do we know in real time what a transitory deviation is? All this, while constructing the real picture is subject to considerable uncertainty in real time, data is revised markedly, and policy is supposed to be forward-looking.
Notwithstanding all these, I believe that the flexible inflation targeting regime in which we operate serves the economy well, and it is the best currently existing framework for conducting monetary policy for the good of the economy, both in terms of maintaining the anchor of price stability, and in terms of the policy’s contribution to growth and employment.
There is one thing of which I can assure you—conducting monetary policy will continue to be exciting in the future, as well.