The Long Road from Adjustable Peg to Flexible Exchange Rate Regimes: The Case of Israel
The stabilization of the exchange rate of the shekel against the dollar was a cornerstone of the program for the stabilization of the Israeli economy, adopted in mid-1985. The program led to a drop in the inflation rate from 400 percent during 1984 and at the beginning of 1985 to a level of between 16 and 21 percent during the years 1986-1991. From the onset of the stabilization program and until 1994, policy-makers related to the exchange rate as a key price anchor, while the interest rate served to moderate capital movements.
When the program was launched, it was initially hoped that stabilizing the exchange rate would lower inflation to Western levels and that it would be possible to maintain a fixed exchange rate over time. However, the inflation rate continued to be relatively high and with time, a cumulative real appreciation necessitated exchange rate adjustments. At first, a policy of discreet devaluation was implemented, while a stable exchange rate was maintained between the devaluations. This policy and the liberalization of the money and foreign currency markets during the 1990's led to repeated waves of speculative capital movements, which eventually necessitated an increase in the flexibility of the exchange rate. The process of transition from a fixed exchange rate regime, with occasional devaluations, to a floating exchange rate lasted from 1989 to mid-1997. One reason why the process of increasing exchange rate flexibility was so protracted, was that such a transition required a conceptual change regarding the exchange rate’s role as an anchor for the general level of prices. However, the increase in exchange rate flexibility, in itself, appears to have been an inevitable measure resulting from the liberalization of the foreign currency market and the development of high-tech industry, which was reflected inter alia by large equity issues abroad from the mid-1990s.
Due to the continuation of double-digit inflation during the years 1986 to 1991 and the upsurge in speculative capital movements, at the beginning of 1992 the Bank of Israel moved to an exchange rate regime that may be described as an upwardly sloping target zone (or crawling band). The aim was to ensure, as far as possible, that the exchange rate itself would rise along the slope. Concurrently, the Bank of Israel began to announce inflation targets. The objective was to gradually reduce the gradient of the slope and the inflation target with it. In 1994, actual inflation greatly exceeded its targeted level, leading to an assessment that the exchange rate could no longer serve as the sole anchor for prices.
From the last quarter of 1994, the Bank of Israel began to use the interest rate as a tool for attaining the inflation targets. Over time and in several stages, the limits of the exchange rate band were expanded, with the intention of moving to a mobile exchange rate regime. At the beginning of 1996, the Bank of Israel announced that it would no longer intervene in the foreign currency market, unless the exchange rate were to approach the limits of the diagonal band. Since mid-1997, except for several days at the beginning of 1998, the Bank of Israel has refrained completely from intervening in foreign currency trading. The exchange rate has been determined by market forces, and the interest rate has served as the only tool for attaining the inflation target.
Experience in Israel indicates that the stabilization of the exchange rate made a substantial contribution to halting the process of hyperinflation. Yet the attempts to manage the exchange rate over time as a means of anchoring prices were unsuccessful. In a small economy that is open to capital movements, it is very difficult to manage the exchange rate and the public is well aware of this difficulty. In fact, the gradual reduction in the inflation rate during the 1990's and the convergence of this rate in recent years to a level similar to that prevailing in the industrialized countries, was achieved despite (or due to) the increased flexibility of the exchange rate and the move to full mobility since 1997.
It should be noted that on the basis of the findings that will be presented below, the increased flexibility of the exchange rate did not appear to have the effect of reducing the extent of the pass-through from the exchange rate to prices. Moreover, the correlation between the pace of depreciation and inflation increased when the exchange rate became more flexible. In other words, changes in prices became more closely correlated with changes in the exchange rate. Concurrently, the sensitivity of the exchange rate to interest rate adjustments also increased. Accordingly, exchange rate mobility enhanced the effectiveness of the interest rate as a tool for the achievement of price stability. But at the same time, exchange rate and price volatility increased, although the volatility in the exchange rate of the shekel (against the currency basket or the dollar) has not exceeded that in the exchange rates of the pound sterling, the euro and the yen (against the dollar). In addition, the rapid expansion of the derivatives markets in Israel during recent years has enabled the private sector to hedge against exchange rate fluctuations.