Israel’s Inflation, Interest Rates Soar, Top Economist Fears for Central Bank’s Independence
The threat to the country’s democratic institutions makes investors take their money and business elsewhere, expert says
The Bank of Israel, Israel’s central bank, announced on Monday that its monetary committee decided to increase the interest rate by 0.5% to reach 4.25%, which is the highest the country has experienced in almost 15 years.
Subsequently, current government coalition members such as Foreign Minister Eli Cohen, and Chair of the Knesset Finance Committee Moshe Gafni, expressed their discontent with the increase in the interest rate.
“I asked the friends of the Minister of Finance Bezalel Smotrich to draw up an outline with the governor of the Bank of Israel to stop interest rate increases,” Cohen tweeted on Monday. “Considering the backdrop of moderate inflation, there was no justification for raising the interest rate today, which continues the maltreatment of mortgage holders.”
Eytan Sheshinski, the Sir Isaac Wolfson Professor of Public Finance Emeritus at the Hebrew University of Jerusalem, is alarmed by these statements. He told The Media Line that his interpretation “is that the independence of the Bank of Israel is in jeopardy,” he said. “I worry about that quite a bit. It is extremely important that the independence of the Bank of Israel will remain intact.”
The interest rate is a reflection of inflation, he explained, noting that it was the move that the experts at Israel’s central bank considered appropriate to moderate inflation.
In response to the foreign minister’s statement, Israel’s Prime Minister Binyamin Netanyahu said on Tuesday that the independence of the central bank will remain intact. “Under my leadership, the Bank of Israel law that guarantees the independence of the monetary committee headed by the governor in determining the interest rate was passed. … Nothing will change it.”
Raising interest rates may lead to unemployment, and this is why the central bank always must balance between anti-inflationary measures such as interest rate increases, and employment
Dr. Yael Hadass, academic head of international programs in Economics at Reichman University, explains that by raising the interest rate the central bank has two goals: “To achieve price stability, meaning to prevent inflation beyond the bank’s declared target which is around 1%-3% inflation per year, and to strive toward full employment and economic growth,” she said.
Hadass told The Media Line that as prices rise, with the yearly inflation of 5.4% seen today in Israel, prices on average increase by the same 5.4% per year; therefore, the central bank raises the interest rate accordingly to suppress demand for goods and services and prevent a further increase in prices.
This action has a domino effect that leads ultimately to a halt of the soaring of prices. When the interest rate rises, she said, loans – such as mortgages taken by households – become more expensive and, as a result, the household cuts spending on other goods.
“Businesses that experience reduced demand on one hand, and who can be in a situation where they have loans as well, must cut spending themselves, which can be reflected in laying off workers or cutting other costs,” she continued.
This leads to the suppression of the demand for goods, which may lead to a halt in the price increase, she noted.
Hadass stresses that this measure has pros and cons so it must be carried out in a balanced manner.
“Raising interest rates may lead to unemployment, and this is why the central bank always must balance between anti-inflationary measures such as interest rate increases, and employment,” she said.
However, Hadass points out that currently employment in Israel is high and the growth rate of the gross domestic product is also high, noting that, according to the central bank, the growth rate in 2022 was 6.5%. “So, the central bank feels confident that it can achieve a halt in inflation without falling into severe unemployment,” she continued.
This is why Sheshinski stresses the importance of the independence of the Bank of Israel.
To support his claim, he illustrates the example of Turkey, where the country’s President Recep Tayyip Erdoğan appointed the governor of the country’s central bank. Erdogan’s theory, he said, “was that the interest rates caused inflation, which no economist subscribes to this theory.” Sheshinski adds that the reality is that interest rates reflect inflation.
As a consequence, Turkey now has a very high inflation rate which is driving it into a problematic situation, according to Sheshinski, who adds that this is “because they tried to suppress what had to be done.”
He also cites an opposite example, in Russia. “You can also see how careful Russia is. Putin basically rules single-handedly in Russia, but he was very careful in letting the central bank governor lead the economic policy, and that was very helpful to the Russian economy,” said Sheshinski.
“He didn’t touch the central bank because he understood how crucial it is for foreign investors and for firms and so forth,” he added.
Sheshinski reiterated that he is worried about the statements coming from the Israeli government’s coalition partners. “Both said: ‘let’s have a path for stabilizing the interest rate,’ which basically means ‘let’s put some breaks on the central bank’s ability to determine the interest rate,’” he said, with the added warning that it is a very dangerous path to tread.
As a whole, the current political instability in Israel may have negative effects on foreign investment, according to Hadass.
“The threat to democratic institutions makes investors take their money and business elsewhere since if the legal system is not free to protect their business actions it is too risky to invest in the country,” she said referring to the ongoing judicial overhaul currently being undertaken by the Netanyahu government. As a result, according to Hadass, many investors are buying dollars and that weakens the shekel.
She believes that this is a very risky situation. It is “the main reason why many leading economists in Israel and abroad warn the government against taking anti-democratic measures that will severely hurt the economy,” she said.
Less money for local investment means both less employment and more expensive foreign currency, which can ultimately lead to higher inflation because many goods sold in Israel are imported, she explained.
Sheshinski adds that the main Israeli export is in the high-tech industry which, if the country’s economy is affected by political instability, will lose its most important asset – manpower, since it will drive many young people and businesses to leave the country and work from overseas instead. In addition, Israel’s credit ranking among the various international agencies will go down, he said.