That was his last sentence, in answer to the last question. The message with which the governor of the Bank of Israel Prof. Amir Yaron the press conference held following the interest rate decision on Monday. One could find in it a professional warning to the new government, and if one wanted to be more dramatic, one could also find in it a sign that the government and the Bank of Israel could be on a collision course.
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● “Preparing the ground for the end of the cycle of interest rate hikes”: Economists’ reactions to the Bank of Israel’s decision
The governor talked about the possibility that the budget that the incoming government will pass will increase the deficit more than forecast, fueling inflation. Such a scenario, implied by the governor’s words, may lead the Bank of Israel to a more rigid interest rate path. Or in the words of Prof. Yaron: “If there is a very, very large expansion even beyond that… it will affect inflation and this is something we will also have to take into account in the future of our policy.”
The budget meets coalition commitments
Let’s take a step back. In its decision this week, the Bank of Israel raised the interest rate to 3.75%, thus completing a course of interest rate increases of 3.65% since last April. According to the forecast of the research division, the interest rate hikes are close to ending: the interest rate should reach 4% this year, and then remain at this level for a period of time. But as the governor emphasized, and as we have already seen in the past year, everything is subject to change. If anything, it seems that the change may be upwards, to a higher interest rate.
Already now, the interest rate of the Bank of Israel is “restraining”, meaning it slows down the activity in the economy. According to the bank’s research division, in the coming year we should see a certain slowdown in growth, to 2.8%, and also an increase in unemployment, to 4% (in the US and Europe, the governor mentioned, growth should be zero). All this, in the name of returning to price stability According to the bank’s current forecast, inflation in Israel is going to remain high for the next two months, and then reverse direction and start to fall. At the end of the year, it should stand at 3%, the upper end of the range to which the Bank of Israel aims, and next year it should return to 2%, i.e. to the destination center.
This forecast is only a forecast, and there are a variety of factors that can disrupt it. “Risks to the forecast”, as they are called in the bank. Some of them come from abroad. For example, the war in Ukraine, a cold winter in Europe that will lead to an increase in energy prices, and the situation in China. But there are also “local risks”, and they come from the direction of government policy.
The incoming government, it is clear, intends to increase expenses, and there are a number of commitments that were included in the coalition agreements. But both the politicians and the Bank of Israel, it is clear that not all of these commitments will come to fruition. This is the nature of coalition agreements. So the forecast takes into account that in practice, the budget will increase “only by a portion of the estimated cost of the coalition agreements”, and in addition, that the wage agreements to be signed in the public sector will include “moderate” wage increases.
But what if the additions to the budget are larger, and are accompanied by a larger deficit? This is the local risk referred to in the bank’s forecast, and the governor also chose to refer to it: “The greater the fiscal expansion, the inflation, the debt-to-GDP ratio and the returns on the capital market are expected to be higher than those shown in the forecast.” What is implied by this sentence, but not explicitly stated, is that all of these will lead the Bank of Israel to raise the interest rate higher. This is how the sentence with which the governor chose to end the press conference can be understood: “It will affect inflation and this is something we will also have to take into account in the future of our policy.”
Can the riot in Britain happen in Israel?
This scenario, of increasing government spending, which will lead to an increase in the deficit, and push the interest rate up, is known from other places. In fact, a similar scenario, although much more extreme, was behind the political drama that took place in Britain last fall. The government of Liz Truss presented an economic plan that includes a massive aid package to subsidize energy prices, along with tax cuts. The result was a spike in interest rates in the markets, chaos in the mortgage market, the beginnings of a crisis in the pension market – and the collapse of the government, in less than a month.
There were those who interpreted the turmoil in Britain as a loss of confidence on the part of the markets. But in fact, the rise in interest rates in the markets actually expressed something else: an understanding that the new government’s economic package will push inflation up, and an expectation that, as a result, the Bank of England will intervene and raise interest rates even more. That is, it reflected confidence that the central bank would take action. This was the analysis he detailed in an interview with Globes Prof. Eitan Ilzetzky, a renowned macroeconomist from the London School of Economics, who visited Israel last month.
So what can Israel take from the upheaval that hit Britain? “First of all”, according to Ilzetzky, “in the current period, of high inflation, of supply limitations, one must be very, very careful with budget expansions.” When the immediate danger is another increase in interest rates, the price of which will be paid by, for example, the mortgage holders.
True, there are differences between the countries. “Inflation in Israel is not as bad as in Britain, maybe there is still a little room to do it here. But any reasonable government should do it with extreme caution.” On the other hand, Ilzetzky also mentions that the Bank of England also enjoys advantages that the Bank of Israel does not have, such as a long history, and the fact that London is a global financial center. These give him extra reliability and room for maneuver.
The scenario we saw in the UK, Ilzky adds, is not the worst: in the end, investors did believe that the Bank of England would act to control inflation, as a counter to the government’s actions. The more worrying scenario, for him, was that the bank would not operate: “The big danger is the loss of independence of central banks.” And this is an issue that the governor also chose to address. “The independence of the Bank of Israel is something that everyone is looking at. There is no economy in the world where the bank’s independence was compromised, and that the entire economy was not harmed. All the decision makers know this very well.”
Not only the amount of the budget: where the money will be directed
It should be said that so far, Finance Minister Bezalel Smotrich expresses himself in a similar spirit. At his inauguration ceremony this week, he spoke about budgetary responsibility, restraint, and maintaining the frameworks. We have to wait and see how these emphases will be reflected in the actual budget. The governor’s message, in any case, is clear.
Final note: there are questions concerning the budget as a whole, such as how much the budget is, and how big the deficit is. But there is also a separate question, which is what the budget contains, and where the money goes. Will it be dedicated to programs that “encourage growth and those that benefit the entire population”, as the governor emphasized? Upon taking office, Smotrich spoke of a budget “biased towards growth and infrastructure development”, but as we have already written here at Globes, investment in human capital and the population as a whole are not exactly the emphases at the heart of the coalition agreements. Here too, you need to see what the actual budget will look like.