The Functions of the Bank of Israel: Managing monetary policy

​As stated in section 4(1) of the Law, one of the Banks functions is "managing monetary policy", the Bank's major area of responsibility and the focus of its influence on the economy. The main objective of monetary policy is to maintain price stability in order to help to create a business environment that supports sustainable economic growth. Price stability is defined in terms of an inflation target that the government has been setting since 1992. The objective of monetary policy is to attain the target.

To attain the inflation target, the Bank of Israel sets the level of short-term interest rates. Too low a level of interest would lead to overexpansion and inflationary pressures, while too steep a rise in the rate of interest would result in excessive restraint of economic activity. Monetary policy, through the interest rate, also affects inflation expectations of the public (individuals and companies) and through them the decisions the public makes on the basis of those expectations.

Experience in Israel and abroad shows that inflation has a distorting effect on vital aspects of the economy--production, consumption, foreign trade, the labor market, and the financial markets--to the detriment of stable economic growth. Hence the importance that the Bank of Israel (like other central banks) attaches to the battle against inflation.

Each month, the Bank of Israel determines the interest rate level that is needed to maintain price stability (or to converge into the range defined as price stability within a reasonable period of time), and to support financial stability, and attain the government's other objectives, primarily growth and employment. To make this decision and as a basis for formulating monetary policy, the Research Department and Market Operations Department formulate an outline of the state of the inflation environment and the forces that affect it by analyzing current information about activity, the labor market and prices, capital market indicators, and using quantitative empirical models that the Bank has developed to predict inflation.

The monetary policy that the Bank of Israel determines is implemented by the Market Operations Department via a range of monetary instruments -- monetary auctions, makam auctions, and repo auctions -- and, when necessary, by intervening in makam and bond trading on the securities exchange.

Monetary auctions for deposits from and/or loans to the banks serve as a major instrument due to the precision and speed of their effect. Through them, the Bank of Israel can affect the money supply and the short-term rate of interest in the money market, thereby preventing undesirable fluctuations in the monetary base resulting from a temporary increase in government monetary activities (e.g., tax collection, net borrowing, or domestic payments). Monetary auctions to the banks are for various fixed periods of one day and one week. When the banks take monetary loans, they provide collateral in the form of government bonds and makam.

Overnight loans: Since September 1, 2005, the Bank of Israel has made a window available to the banks for monetary loans, without a quota, at an interest rate currently 0.25 percent above the Bank of Israel published rate. The loans are provided for one day, against collateral, and repaid automatically the next business day.

Overnight deposits: Since September 1, 2005, the Bank of Israel has made a window available to the banks for local currency deposits, without a quota, at an interest rate currently 0.25 percent below the Bank of Israel published rate. The deposits are for one day and are repaid automatically on the next business day.

The makam (a Hebrew acronym denoting "short-term loan") is a short-term security (up to one year) that the Bank of Israel issues to affect the monetary base and the rate of interest in the money market. The sale of makam to the public reduces the monetary base, and thus serves to restrain activity and inflation. The purchase of makam by the Bank of Israel or their redemption by the public injects money into the market and thus encourages economic activity. Makam resemble deposit auctions in their effect on the monetary base, but because they are issued to the public and their yield is determined in trading on the stock exchange, they reflect the public's expectations regarding inflation and changes in monetary policy, information that helps the Bank of Israel to plan its monetary steps.

Repo: The Bank of Israel has been performing repo transactions in the capital market since October 17, 2007. In this activity, which it performs by way of auctions, the Bank purchases bonds and makam from institutional entities and banks and sells them back a week later at a predetermined price (as distinct from the repo transactions that the Bank performed in 2004-2006, in which it sold makam and bought them back a week later). Repo is one of the most important financial instruments in the international markets; the number of transactions culminated in this manner in developed markets is growing steadily. Repo transactions are among the most important tools for the management of interest rate policy by central banks in many countries.

The reserve requirement
obliges banks to deposit with the Bank of Israel a certain proportion of the money deposited with them by the public. Until the early 1990s, the Bank of Israel used changes in the reserve requirement as an instrument of monetary policy, but it no longer does so, and the level of the requirement is similar to that in the industrialized countries.