Conducting Monetary Policy
The Bank of Israel's main function is to protect the value of the local currency – in other words, to maintain price stability. Additional functions are to support the attainment of the other goals of the government's economic policy, especially growth, employment, and the narrowing of social gaps, as well as the stability and proper activity of the financial system – all these provided that price stability is not undermined in the long run. Maintaining the value of money is important for economic stability and strength, and for creating the conditions necessary for continued growth of output and employment. The value of money is reflected by the prices we need to pay for goods and services. Price increases – inflation – reduce the value of money, as the same amount of money can buy less.
Why is it important to avoid high inflation?
Inflation means that for the same amount of money, people can buy less. This leads to a lower standard of living and less satisfaction from economic endeavors like labor. In addition, inflation creates uncertainty about the future value of money, so that individuals and economic entities invest time and effort in financial activities to protect against the erosion of the value of their money and uncertainty. Such activities reduce their efficiency and productivity, which hinders the economy from achieving its potential output. Uncertainty about the future value of money also has a negative impact on the profitability of investments, deters long-term investment, and increases the risk premium required by investors and savers. High inflation also affects the economy's credit rating, thereby increasing the cost of credit and reducing the amount granted.
What is price stability?
Israel's government, in consultation with the Governor of the Bank of Israel, sets a price stability target – a desired annual rate of increase in the Consumer Price Index (CPI) that represents a balance between economic stability and economic growth. The current target is between 1 percent and 3 percent a year, and the Bank is obliged to strive to achieve that goal. Some prices of goods and services will increase by more, and some by less, but the intention is that the prices of goods and services included in the CPI will increase on average at a rate within the target range. The aim is not to achieve as low a rate of inflation as possible, and downward deviations from the target are considered in the same way as upward deviations.
How is price stability achieved?
To achieve its objectives the Bank of Israel has a number of policy instruments in its arsenal, the main one being the short-term interest rate, which is set by a Monetary Committee headed by the Governor. That interest rate – the Bank of Israel interest rate – is the basis of the interest the Bank charges the commercial banks on the liquidity it makes available to them and of the interest it pays the banks on their deposits with the Bank of Israel. The Bank sets the rate of interest at a level that will keep inflation within the target range, or that will return inflation to within the range in a period of not longer than two years. The Bank is independent in setting the short-term rate of interest and in using other monetary instruments to achieve its goals. The Bank's interest rate serves as the basis according to which a range of interest rates are set in the economy, including the rates of interest that the public (households and businesses) pays the banks on short-term loans and the rates of interest that it receives from the banks on its short-term deposits.
The interest rate levels affect expenditure and savings, and hence, prices. A rate of interest that is too low discourages households and businesses from saving and makes it cheaper to borrow, encouraging them to increase expenditure, leading to upward pressure on prices, while an interest rate that is too high discourages borrowing and excessively reduces demand and investment, leading to a slowdown in economic activity and to unemployment. Thus, in times of inflation the Bank increases the interest rate, and in times of recession and economic standstill, when there is no inflationary pressure, it lowers the interest rate.