Central Banking

Interview with BoI governor David Klein

With the Middle East teetering on the brink of armed conflict, weinterview the newly appointed governor of the Bank of Israel, DrDavid Klein.

Q. What is the state of Israel's economy at themoment?

After a few years of relatively slowgrowth, we are now on our way toexhausting the potential of the economyto grow at an annual rate of some 5%.This is export-led growth and, hence, itdoes not entail an increase in the balanceof payments deficit. The unemploymentrate peaked last year at 9%. In the firsthalf of this year unemployment hasdeclined to 8.5%. But the inflation rate hasalso remained low. We are likely to endthe current year with inflation lower than2.5%.

Q. What are the implications for the economy, in the short and mediumterm, following the suspension of the middle East peace process?

A. The economic implications depend on the nature of this"suspension". I assume that the peace process is irreversible inone way or another, and, therefore, the medium termrepercussions for the Israeli economy of these recent events willnot be material. This means the government will stick to itscurrent macroeconomic strategy to maintain fiscal discipline,price stability, trade liberalisation and structural reforms.

Q. Have there been any major changes in the Bank's monetary policyframework?

A. It is noteworthy that the government decided, for the first time,on 16 August 2000, that:

* The target of monetary policy is price stability;

* We define price stability to be in the range 1% - 3%;

* We are going to attain it by the year 2003.

In addition the government has decided to gradually reduce thebudget deficit so that it reaches 1.25%, according to ourdefinition, in 2003. This means that the general governmentdeficit, according to European definition, will be some 3% inthat year.

Q. There has not been a deputy governor at the Bank of Israel for quite afew years. However, the finance minister, Avraham Shochat, said inJanuary that he would like to appoint one. It has been suggested this wasto counterweight the power of the governor. What do you think of hissuggestion and will it come about?

A. The current law calls for appointing one or two deputygovernors. This idea is not that they will serve as counterweightto the governor but that they will assist him. I have no problemwith that. I should add, though, that since the Bank of Israel wasestablished 46 years ago, the bank has operated most of the timewithout deputy governors.

The optimal timing for such a change is in the framework ofenacting a modern central bank law, as proposed by acommission appointed by the prime minister (headed by MrLevin, a former supreme court judge.)Israel, along with New Zealand and Oman, are among the few countriesin which the governor of the central bank decides monetary policy on hisown, albeit with the advice of the senior monetary forum (whichincludes heads of the monetary, research, foreign currency and foreignexchange control departments). However, you agree with the financeminister's plans for adopting a "monetary policy council", headed by thegovernor, composed of experienced professionals in relevant spheres.

Q. Why would a committee benefit the monetary policymaking process andhow many people should be on it?

A. The "monetary policy committee" (MPC) is part and parcel of theLevin committee's recommendations which proposed a fivemember council. Such a council may be relevant, if appointed inagreement with the governor, in the framework of a new lawthat renders the central bank operationally independent andwhose mission is to maintain price stability. Taking care thatthere will not be any conflict of interests, the decision makingprocess can benefit from the experience of outside professionals.

Q. You have a much larger governmental role in the economy that mostcentral bank governors because you are also the government's chiefeconomic adviser - i.e. giving advice on minimum wage legislation andtax reform etc. Jacob Frenkel said that there were costs and benefits fromthe governor having dual roles. The costs in terms of perceived reducedindependence from the government and the benefits in terms of beingclose to the macro policymaking process. Frenkel called it a "delicatebalance". But he went on to say, "each governor of the bank has foundhis own way". What would you say is going to be your way?

A. Unlike some other countries, in Israel we don't have aninstitution like a Council of Economic Advisers. We effectivelyfulfil this role and, within the central bank, it is carried out bythe research department. I don't see any conflict of interestsbetween that role and our mandate to maintain price stability,particularly now after the government decided that this is anational goal. In my view the research department ought todevelop its capabilities to advise the government on majorpolicy issues.

Q. The Bank posted a "loss" - a deficit of operating costs over revenues - ofover 4bn shekels in the first half of 2000 and a cumulative loss of 8.7bnshekels at the end of 1999. (NIS 4.1 = $) What were the reasons for theloss and does this have any adverse impact on the bank's independencefrom the government?

A. The reason for the "loss" lies in the events that took place in theyears 1995-97 when we had to intervene in the foreign currencymarkets to prevent the shekel from strengthening and, at thesame time, attain the inflation target fixed by the government.We had then accumulated foreign exchange reserves and,simultaneously, mopped up the resulting excess liquidity byincreasing our liabilities, in domestic currency, to the public. Aslong as the domestic rate is higher than the yield on our foreignexchange reserves, and there is no devaluation, we will carry aloss on our books. We said at the time, and we continue saying,that an inflation target regime is not consistent with anexchange rate band, and the latter ought to be phased out.This does not have an adverse impact on the Bank'sindependence. The fact is that we were able to make significantprogress towards price stability.

Q. Inflation at just 3% is now in the government'starget zone for the years 2000-2001 and economicconditions in Israel are looking fairly good at themoment. Indeed, the fact that inflation mightundershoot its target has enabled the bank toreduce interest rates on a gradual basis. Is this setto continue or will interest rates remain steadyfrom now on?

A. We assume that there is some scope forfurther reducing interest rates, but thatdepends on circumstances. We assessthe situation on a monthly basis andmonetary policy from now on will aimat maintaining price stability.

Q. Your cautious policy of graduated reductions in interest rateshas been commended in the local press. "In the battle againstinflation, haste makes waste," one editorial recently said. Doyou agree with the newspaper's statement?

A. We have been working for a long time to reduce inflation.Cultivating a stable prices culture takes time. From the currentviewpoint, where inflation is already lower than it ever was,there is no need to hurry. In the meantime, there are somelegacies from the high inflation period which ought to beabolished. The government should take the lead here inreducing its indexed linked debt, in removing linkage clausesfrom its contracts and in adopting the European definition ofthe government deficit.

Q. Does the continuation of reduction in interest rates depend onwhether the government maintains its commitment tolowering the budget deficit and whether it brings through thenecessary changes to the Bank of Israel law?

A. Price stability cannot be maintained without fiscal discipline.Since all Israeli governments in the last decade committedthemselves to low deficits, there is no question on this score.Revising the Bank of Israel law, in the way many countrieshave done in the last decade, is not a prerequisite to attaininglow interest rates. Nevertheless, it may be helpful since it willenhance the credibility of the central bank.

Q. The government is in the process of defining a formal inflation target of1%-3% for the long-term not just the year ahead, as price stabilitybecomes more entrenched. But for now the inflation target is still set yearby year (e.g. 3%-4% in 2000, 2.5%-3.5% in 2001, 2%-3% for 2002, and 1%-3%- a range which is now defined by the government as price stability -from2003 onward). Will establishing a firm and unchanging pricestability target give the bank more credibility, allowing the inflationtarget to be reached at a lower average nominal interest rate and withlower interest rate volatility?

A. The government's commitment to maintain price stability, as it wasdecided on 16 August 2000, will definitely enable us to attain thetarget at a lower, and less volatile, interest rate. The recentdecision of the government means that from 2003 onwards therewill not be annual targets. Hence the recent decision was the lasttime the government fixed the inflation target on an annualbasis.

Q. And this change should be adopted in the new Bank of Israel law?

A. It may affect the language of the law, but it is too early to tell.The point is not whether price stability is a target for the centralbank, but whether it is the overriding target.

Q. What are the potential risks that could cause the bank to miss its targets?For example, a large depreciation of the shekel, caused by the lowinterest rate differential with the US and a consequent outflow of capital(the differential has fallen from 8.75% in January 1999 to 2.4% today),could increase inflation substantially.

A. Monetary policy should be forward looking and cautious. Ifconducted in this way it is hard to see domestic reasons formissing the inflation target, either way. The major risks can flowfrom sudden external developments, since the Israeli economyis an open one, relying as it does on international trade and freecapital flows. Such events should be dealt with on the merits ofeach case. We still have to learn how the narrowing interest ratedifferential affects our capital account, and what are theimplications of exchange rate changes for prices.

Q. There is much current political uncertainty with the election of a newpresident, Moshe Katazv, and an increased likelihood of early elections.What problems has this caused the bank and how is this uncertaintyfactored into monetary policy / exchange rate decisions - e.g. has thisdelayed the shift to the official free float of the shekel and the income taxreform plans?

A. The election of a new president does not have any bearing onthe Bank of Israel. On the other hand, political stability is alwaysan important factor in the ability to implement structuralreforms and there is no reason to assume now that such stabilitywill not be maintained.

Q. If there were early elections, is there a risk that the government would goon a "spending splurge" meaning interest rates would have to go up atan awkward time?

A. Early elections do not leave enough time for a "spendingsplurge", especially when we operate within a budget deficittarget regime. In addition, the Israeli public is mature enough torealise that there is no free lunch.

Q. The dual exchange rate and inflation target have been very successful inIsrael in reducing inflation. But you recently said that if there was aperiod of calm the exchange rate target should be abolished because ofthe obvious conflicts between the two objectives, which mean that theyboth cannot be met all of the time. Have we now reached that period ofcalm when the exchange rate target can be abolished?

A. As long as we don't have to intervene in the foreign exchangemarket to maintain the limits of the bank - the time is ripe toabolish it. However, such a step requires the approval of thegovernment, which may have other considerations, likeprotecting "traditional" industries in development towns.

Q. Much foreign exchange market liberalisation has already taken placeover the last few years. When do you hope that all foreign exchangecontrols will have been eliminated?

A. The question is being discussed now, and it has to do withallowing institutional investors to operate abroad. In our view,it should not take a long time before the shekel is fullyconvertible but, again, it is up to the government to decide. Werecommend removing the remaining restrictions gradually butwith a known timetable, especially because institutionalinvestors need time to change their investment strategy.

Q. Would there be adverse effects on the ability of the bank to intervene inthe foreign exchange markets, if the need arose?

A. If we intervene to prevent the shekel from strengthening, it mayadversely affect our ability to maintain price stability.We don't see now much of a chance that we will have tointervene to prevent the shekel from weakening.

Q. The IMF recommended in its Article 4 consultation that the bank"should take a more prominent role in shaping the public's inflationexpectations through a more comprehensive public presentation of itsown analysis for the prospects for inflation". What is the bank doing onthis?

A. We are developing analytical tools that will enable us to forecastinflation under different scenarios. As a matter of fact, we areincreasingly using them in our decision-making process.

Q. You are known for being a strong advocate of the developmentof Israel's capital markets, coming up with many innovativesuggestions. Indeed, in one of the banks press releases it wasnoted that Israel's money markets lack a deep and liquid repomarket. What can the bank do to promote the development ofthe repo market and what would be the benefits for theeconomy and financial system?

A. The emphasis should be on developing non-bank financialmarkets. It is especially noteworthy that we don't have acorporate bond market. This is partly due to tax distortions,partly to commercial banks' ownership of institutionalinvestors, and partly to constraints imposed by the securitieslaw.

Q. What changes are needed to reform the capital markets?

A. The focus should be on liberalising the pension funds industry.This is a highly concentrated industry and most of its portfoliois not tradable. In addition, there is a significant pay-as-you-gopublic pension scheme. All those elements are well known, butchanges are subject to an agreement with the labour union.

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