Lecture by the Bank of Israel Governor at the Israel Economic Association Conference: Monetary Policy During the Coronavirus Crisis
- Monetary Policy has had two major functions during the corona crisis: ensuring that the financial markets are operating properly, and easing the terms of credit in the economy. The Bank of Israel worked determinedly and took unprecedented steps to achieve these goals.
- The wave of withdrawals from the mutual funds as a result of the price declines in the equity markets and the structure of institutional investors’ holdings of assets abroad led to the creation of liquidity distress in the bond and foreign exchange markets. The Bank of Israel acted quickly to provide liquidity to these markets, and the markets returned to proper functioning.
- It is important that investors understand the risks inherent in activity through derivative instruments, and that there may be sharp movements in the exchange rate in the direction of depreciation as well. They should take these into account when hedging risks and managing their portfolios.
- The Monetary Committee’s actions in the bond and credit markets, lowering the interest rate, and measures by the Banking Supervision Department, prevented an increase in the costs of financing credit despite the increased risk.
- The real interest rate is very low, which supports the ability of households and businesses to take out credit and the expansion of investments in the economy, and enables the government to finance the deficit under easy terms. As long as the deficit is a direct result of the crisis, and even if it grows slightly to finance policy measures that encourage growth and productivity, the financial markets will allow the government to continue financing the deficit at low interest rates.
- As long as there is no inflationary outbreak, the Bank of Israel will continue supporting the economic recovery through a low monetary interest rate, and the real interest rate will remain low, and perhaps even negative, along a large portion of the curve. If necessary, the Bank of Israel will take additional steps to directly support the credit market.
- The low interest rate will continue to serve as the main tool for returning inflation to within the target range, and later to around the midpoint of the range. If necessary, the Bank of Israel will continue intervening in the foreign exchange market.
The Bank of Israel began planning for the corona crisis even before anyone could assess the extent to which the crisis would develop. On February 2, in the entire world outside of China, there was one death as a result of corona, and just 146 verified cases of the disease. On that day, I gave instructions for the Bank of Israel to establish an interdepartmental team to begin analyzing the implications of the crisis for the Israeli economy. Since then, the pace of developments has been exponential. A great many things that none of us even imagined have taken place, and the Bank of Israel found itself taking steps that, at the beginning of February, had seemed almost fanciful. Even though the Bank of Israel was very active both in its role as economic advisor to the government and in its supervisory roles, my lecture today will focus on the central bank’s classic function—monetary policy.
The fact that the policy interest rates at many central banks have for a long time been near the lower bound has led many to wonder what the central banks would be able to do in the event of another crisis. At the Bank of Israel, we asked ourselves what role monetary policy would have in view of the fact that the interest rate was at a very low level. As I will show today, the Bank of Israel’s monetary policy had two main functions in this crisis. First and foremost, it acted to make sure that the financial markets were functioning properly—a tremendously important and necessary condition for the continuation of economic activity despite the restrictions and for the economy to be able to provide for the population’s essential needs. This was in addition to the classic function of monetary policy during an economic crisis—to ease the terms of credit in the economy in order to support the financing needs of households, businesses, and the government.
At the end of February, when the Monetary Committee convened for its scheduled meeting to decide on the interest rate, as it does eight times per year, all of the macroeconomic data were still pre-crisis data. And they told the story of strong growth, low unemployment, low inflation, and appreciation of the shekel that we had gotten used to seeing in recent years. However, the crisis was already just around the corner, and even though we couldn’t assess its intensity, we did think it proper to note that if the crisis persisted and grew more serious, we would be able to use a variety of tools to increase the extent of monetary accommodation. Some of this variety was used over the course of the coming weeks, as I will show (Slide 3).
The first challenge—the failure of financial markets
In order to explain the causes of failure in the financial markets, we must present a number of characteristics of the structure of holdings of financial assets in Israel prior to the crisis. The share of institutional investors in the government bond market increased persistently in the past decade with the growth of the volume of Israelis’ pension assets, as institutional investors and mutual funds hold close to half of all tradable government bonds (Slide 4). In addition, the institutional investors persistently increased the portfolio’s exposure to foreign assets. It is particularly important to know that a significant share of institutional investors’ investments in foreign equities is done through derivatives. For various reasons, the institutional investors prefer this method over directly holding equities. As we will now see, this was very significant in terms of financial developments in Israel at the height of the crisis (Slide 5).
Toward the end of February, the medical crisis began developing more rapidly outside of China—first in Italy, then in other European countries. The reaction in the global financial markets was particularly harsh (Slide 6). To illustrate, during March, there were days when the daily fall of the S&P 500 index—10–11 percent per day—was sharper than on the worst days of the 2008 Global Financial Crisis. The drops in the market created a pincer effect that threatened to paralyze the financial system in Israel (Slide 7). They led to a massive wave of withdrawals from mutual funds at unprecedented volumes (Slide 8). The funds found themselves in liquidity distress and turned to the market, which is usually the most liquid, and sold government bonds at "fire sale" prices in order to take on cash that would enable them to liquefy the assets of investors who were liquidating their holdings in the funds. The government bond market was thrown into major distress, and the pressure in the financial markets increased (Slide 9). At the same time, the institutional investors met margin calls when the brokers through whom they held derivative instruments on equity markets abroad demanded that they hold liquid collateral in view of the declines on the equity markets. The institutional investors needed dollars—lots of them, and quickly. In order to finance the purchase of these dollars, the institutional investors also began selling off government bonds, intensifying the problem that had started with the mutual funds. The institutional investors sought a dollar liquidity solution in the swap market—where they could borrow dollars in the short term in exchange for shekels, and then recoup the shekels in return for dollars, without having to expose themselves to the exchange rate. However, the dollar liquidity distress developed simultaneously in many markets around the world, and the implied interest rate in the swap market, which, in a normal situation should reflect the interest rate gaps between currencies plus the expected change in the exchange rate over the contract period, dropped to levels that reflected a major market failure (Slide 10). The investors were forced to seek a solution in the spot market as well, which led to a strong, even unprecedented, depreciation of many currencies against the dollar, including the shekel (Slide 11).
In mid-March, a few days after the pressure in the financial markets began, the Bank of Israel decided to intervene in the markets in order to ensure their proper functioning. The failures in the bond market and in the foreign exchange market could have led, for instance, to savers not being able to sell their bonds at the price set in trading, and exporters not being able to access the foreign exchange market and fix the desired exchange rate at that time against future conversions. The markets were not functioning. Therefore, the Monetary Committee convened for an unscheduled conference call late on Saturday night March 14, and again early Sunday morning. Following these meetings, the Bank of Israel announced a series of measures, similar to those being taken at that time by the major central banks (Slide 12):
- The Monetary Committee decided (March 15, 2020) to purchase government bonds in the secondary market, and also to make repo transactions with government bonds as collateral with financial institutions, thereby injecting liquidity into the market and ensuring that the government bond market functioned properly. (The program was later expanded to include corporate bonds as collateral, an unprecedented step on its own that increased investors’ confidence in their abilities to liquefy assets later on.)
- On March 16 and March 18, the Bank of Israel announced that it would engage in dollar/shekel swaps of up to $15 billion in order to provide dollar liquidity to the financial sector. We were able to provide this dollar liquidity to the economy thanks to the foreign exchange reserves the Bank of Israel has accumulated.
In perspective, I can say with some satisfaction that these measures were quite effective, and succeeded in calming a large part of the panic and in returning the markets to proper functioning. The direct correlation between the volatility in the equity markets and the withdrawals from the mutual funds and foreign exchange conversions by the institutional investors disappeared (Slide 13), and in the following days, the institutional investors stopped buying foreign exchange and the withdrawals from the mutual funds dropped to near zero (Slide 14). The pressure in the financial markets declined (Slide 15), the shekel/dollar swap market returned to normal functioning (Slide 16) also as at the same time the Fed began providing dollar liquidity to central banks around the world, and the exchange rate returned to near the environment in which it had been prior to the crisis (Slide 17).
It is important to note that alongside the need to act quickly and make sure that the markets were functioning properly, it was important to us to also create market discipline, and to ensure that those active in the markets would internalize the various risks for the future. In particular, it was important that investors understand the risks involved in activities involving derivative instruments, and that there may be sharp changes in the exchange rate in the direction of depreciation as well, and that they take all this into account in hedging their risks and managing their portfolios.
The second challenge—increased financing costs and credit difficulties (Slide 18)
The financial markets returned to functioning, and we now turned to dealing with the credit market. At the height of the crisis, when the closure was at its greatest, we asked ourselves whether there was room for monetary accommodation at such a time. Monetary accommodation is intended to encourage demand, and in the initial days, economic activity was halted and a large part of the economy was prevented from producing, such that the crisis began essentially on the supply side.
However, the negative impact to the income of businesses and households created an urgent need for credit, which would allow them to bridge that impact, continue to consume in order to maintain households’ standard of living as much as possible, and enable businesses to meet their obligations toward their suppliers. During March, we began to see evidence of an increase in the interest rate on credit in various segments, with an almost complete halt of nonbank credit. The crisis led to a sharp increase in risk, and while bond spreads stabilized (Slide 19), they were at significantly higher levels than the lows that we had seen prior to the crisis. The increase in yields (Slide 20) had an impact on the cost of financing the government, which had to finance the expected increase in the deficit as a result of both the slowdown in economic activity and the broad assistance program announced by the government. In parallel, there was an increase in corporate bond spreads (Slide 21), meaning the cost of financing of broad parts of the business sector, and the spreads of bank bonds increased, having a direct effect on the cost of the banks’ sources and on the prices of bank credit (Slide 22).
At this stage, we still believed that there was no room to lower the interest rate before the scheduled date, because the level of the monetary interest rate was already low, and the main cause of the increase in credit costs was the developments in the bond market. Therefore, on March 23, two weeks before the scheduled date of the interest rate discussions, the Monetary Committee decided on a step of unprecedented scope, and announced that the Bank of Israel would purchase government bonds totaling NIS 50 billion—three times (or twice in terms of market value) the amount of bonds that the Bank of Israel purchased in 2008–9 (Slide 23).
Two weeks later, we convened for our regular interest rate meeting. If there were still hopes in March that the medical crisis would end quickly and that the economic crisis would subside with it, at the beginning of April, it was already more clear that we were facing a prolonged crisis and that we could also expect a negative impact to demand in view of the decline in the income of many households and the drop in value of financial assets. The Monetary Committee therefore decided to lower the interest rate from 0.25 percent to 0.1 percent. While this is a small step in terms of its scope, it did make it easier for a large portion of borrowers whose loans are indexed to the prime rate, and it reflected the Monetary Committee’s commitment to use every possible tool to support the economy at this time. In parallel, the rapid data that the Banking Supervision Department put together showed that while the banks were injecting credit at unprecedented levels to the mortgage market and to large businesses—most of which were using agreements and facilities signed in advance—credit to small businesses declined, and the state-guaranteed loan fund was still in its infancy. The Monetary Committee decided to launch a special program to incentivize the banks to divert credit to these businesses, and announced that the Bank of Israel would grant the banks three-year monetary loans at an interest rate of just 0.1 percent, provided that the banks would show that they were providing credit to small businesses. By the end of May, credit totaling NIS 4.6 billion had been provided to such businesses as part of this program.
The Bank of Israel’s measures had an immediate impact on yields in the government bond market (Slides 24 and 25), the corporate bond market (Slide 26), and the banks’ costs of financing (Slide 27). In parallel, back at the beginning of the crisis, we told the banks that if they made their credit policies more rigid, it would be more difficult to get through the crisis. In contrast, if the banks eased their credit policies even slightly, they would help businesses and households survive the crisis. We didn’t make do with just statements, as we took a variety of steps in our role as the banking regulator to incentivize the banks and enable them to increase the supply of credit (Slide 28). In particular, in view of the concern that expected credit losses would bring the banks close to their minimum capital adequacy ratios, we lowered the capital adequacy ratios by one percentage point. We also created an accounting infrastructure that made it easier for the banks to defer loan repayments for customers who requested it, and we later published a framework for deferring loan repayments for all economic sectors, as part of which payments totaling more than NIS 6 billion have been deferred so far (Slide 29).
As a result of all these actions, the data show that at the very least there was no sweeping increase in the interest on credit in the economy (Slide 30), and that when the government-backed loan fund finally began to operate, it led to a decline in the interest rate on credit to small businesses (Slide 31).
In conclusion, a few words about the role of monetary policy moving forward.
We must remember that the crisis is first and foremost a health crisis, which became a serious crisis in the real economy. Thanks to the determined actions of the Bank of Israel and other central banks, the crisis did not become a financial crisis, and an even more severe negative impact on people’s standard of living was avoided. The real nature of the crisis puts most of the burden for handling it on fiscal policy.
During the crisis, there were voices calling on the Bank of Israel to use the foreign currency reserves to finance the government’s anomalous costs. It is important to remember that the foreign exchange reserves are not a wealth fund. The foreign exchange assets are balanced by shekel liabilities, and the reserves are not a source of fiscal financing on their own. The reserves can be used as a source of foreign currency or short-term liquidity when there are extreme foreign currency shortages—as they were in this crisis.
The real interest rate in the economy is low (Slide 33), which supports the ability of households and businesses to take out credit and expand investments in the economy. In addition, the interest that the government of Israel pays on its debt is very low, partly thanks to the Bank of Israel’s intervention in the bond market. Therefore, at this time, the government can finance the increase in the deficit under easy conditions.
So what is the role of monetary policy in the foreseeable future?
- As long as the deficit is the direct result of the crisis, and even if it grows a little in order to finance policy measures to encourage growth and productivity, the financial markets will allow the government to continue financing the deficit at low interest rates.
- As long as there is no inflationary outbreak, the Bank of Israel will continue supporting the economic recovery through a low monetary interest rate, and the real interest rate will remain low, and even negative, along a large portion of the curve. The Bank of Israel will continue to purchase government bonds, and if necessary, it will take additional steps to directly support the credit market.
- The low interest rate will continue to serve as the main tool for returning inflation to within the target range, and subsequently to around the midpoint of the range.
- The Bank of Israel will continue intervening in the foreign exchange market as long as the monetary committee’s assessment is that the exchange rate is diverting from the dynamic window that is consistent with returning economic activity to a solid level and with price stability.
- As the Monetary Committee clarified, it will expand the use of the existing tools, including the interest rate tool, and will operate additional ones, to the extent that it assesses that the crisis is lengthening and it is necessary to achieve the monetary policy goals and to moderate the negative economic impact created as a result of the crisis.