Remarks by Andrew Abir, Director of the Bank of Israel’s Market Operations Department: “Monetary Policy in the Era of Low Inflation”

Andrew Abir, Director of the Bank of Israel’s Market Operations Department, delivered a lecture today at the IBI investment firm, discussing the monetary policy conducted by the Bank of Israel during the low inflation era.  He mentioned the Bank of Israel’s goals as defined in the Bank of Israel Law, and the tools with which it can act to achieve its targets.  The main tool is, obviously, the interest rate, which has been at the low level of 0.1 percent since 2015 in view of the decline of inflation to below the 1–3 percent target range.  Abir mentioned that while the Federal Reserve began a gradual process of raising interest rates, a number of central banks, chiefly the ECB, are maintaining a negative interest rate policy.  While the interest rate affects short-term yields, other tools can impact long-term bond yields.  Similar to other central banks, the Bank of Israel uses “forward guidance”, and other central banks have used bond purchasing policies—some still do—which significantly increases their balance sheets.  Another tool is intervention in the foreign exchange market, which also contributes to increases in the central bank’s balance sheet.  In January 2018, the Bank of Israel intervened significantly in the foreign exchange market, including after it identified significant selling activity based on models.  The major intervention halted the appreciation of the shekel, despite the marked weakness of the US dollar vis-à-vis the other major currencies.

 

Is monetary policy succeeding in meeting its targets?  The labor market is at full employment, and the economy is growing in line with its potential growth rate.  The main transmission mechanism from monetary policy to real activity has, in the past several years, operated mainly through the policy’s effect on private consumption, which has led economic growth.  However, the inflation environment remains below the target.  Some of the decline in inflation reflects the “import” of low inflation from abroad which, together with the effect of the shekel’s appreciation, leads to a decline in the prices of tradable goods.  In Israel, inflation was also impacted by price reductions initiated by the government, while structural changes that are increasing competition in the market are acting to reduce inflation.  These are desirable changes that are affecting price levels, and monetary policy is not trying to act against them or to offset them.  However, a prolonged decline of the inflation rate to below the target may have negative ramifications for economic activity over time, and the Bank of Israel’s monetary policy is therefore expected to remain accommodative as long as necessary in order to entrench the inflation environment within the target range.

 

Abir discussed the gaps in consumer price levels between Israel and other OECD countries, and noted that there is a high correlation between the level of the real exchange rate and the price gap.  Currently, the shekel is appreciated, so price levels in Israel are higher than abroad, since the appreciation lowers prices abroad in shekel terms more than prices in the domestic economy, where it only affects the prices of tradable goods.  A real depreciation may narrow the price gap, as it was, for instance, in the middle of the previous decade.​