Israel: Selected Issues Paper
Author: International Monetary Fund
Publication Date:
02 Apr 2012
eISBN:
9781475502732
Language:
English
Keywords:
ISCR; CR; bank; central bank; inflation targeting; inflation; staff salary determination; organic law; routine publication; interest rate; modus operandi; Price stabilization; Consumer price indexes; bank protocol; bank law
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This Selected Issues Paper states that Israel’s growth performance is impressive, with real GDP growing at a faster pace than many other OECD countries. The secular Jewish population enjoys a high level of living standards, whereas most Arab and Haredi people are poor, with poverty incidence reaching 60 percent for both groups. Low employment in Arab and Haredi communities is mainly accounted for by the low employment rate of Arab women and Haredi men.

Abstract

This Selected Issues Paper states that Israel’s growth performance is impressive, with real GDP growing at a faster pace than many other OECD countries. The secular Jewish population enjoys a high level of living standards, whereas most Arab and Haredi people are poor, with poverty incidence reaching 60 percent for both groups. Low employment in Arab and Haredi communities is mainly accounted for by the low employment rate of Arab women and Haredi men.

III. Inflation Targeting in Israel Twenty Years on1

The new Bank of Israel (BoI) Law heralds key institutional innovations to Israel’s monetary framework that align the Bank’s de jure set up with that of the world’s most modern inflation-targeting (IT) central banks. A number of important developments to the practice with which monetary policy is currently conducted in Israel are considered.

A. The 2010 New BoI Law

1. Since its introduction, Israel’s inflation targeting (IT) framework has delivered important macroeconomic results. In 1992 Israel adopted an inflation targeting policy together with a crawling exchange rate band regime with the aim of reducing the rate of inflation. As a result, by the year 2000, inflation had been successfully reduced from double digits to low single digits where it has stayed. And despite considerable inflation volatility, prices experienced moderate acceleration in the 2000s decade, with inflation remaining at all times within single digits.

2. The framework weathered severe shocks well, including wars, the bust of the dot-com bubble in 2000, and the 2007–09 global financial crisis.

3. However, throughout this period, the Bank of Israel was operating under a law dating back to 1954, which had become increasingly obsolete both in terms of changes in the Israeli and the global economy. In particular, although in 1985 the Bank’s law had been amended to prohibit the government from asking the Bank to print money for it (via the “Non-Printing Law”), the Bank’s de jure independence remained more restrictive than its de facto independence. At the same time, the 1954 law still assumed foreign-currency controls long time after Israel had shifted to a flexible exchange rate.

4. This may partly explain some of the difference in macro outcomes over the 2000s compared to Israel’s IT peers. Although Israel’s inflation outcomes have improved dramatically in the second decade since adoption,2 over that decade, advanced and emerging markets countries’ (like Peru) have had a stronger performance on some dimensions. And while in part, the better performance of Israel’s advanced economy peers may be ascribable to the fact that Israel faced severe shocks, including of geopolitical nature, countries in the emerging markets comparator group also lived through important disturbances over the period of comparison, notably the Argentina crisis in the early 2000s, the huge upswing between 2006–08 in commodity and fuel prices which feature prominently in these countries’ CPI baskets, and last but not least political turmoil and natural disasters.

5. In March 2010, following a long gestation, the Knesset passed a new Bank of Israel Law, which became effective on June 1, 2010. The new law leaves the Bank’s modus operandi largely intact but now formally states that the Bank’s main objective is to maintain price stability. In addition, while under the new law the Bank remains the regulator of the banking system, the new law now grants the Bank the objective to support the stability of the whole financial system.

uA03fig01

Israel: Historic Performance Compared

Citation: IMF Staff Country Reports 2012, 071; 10.5089/9781475502732.002.A003

uA03fig02

Israel vs. EMEs Performance, 2002–11

Citation: IMF Staff Country Reports 2012, 071; 10.5089/9781475502732.002.A003

uA03fig03

Israel vs. Advanced Economies’ Performance, 2002–11

Citation: IMF Staff Country Reports 2012, 071; 10.5089/9781475502732.002.A003

6. The new law grants operational independence to the Bank of Israel. A Monetary Committee—as opposed to the Governor alone—now determines monetary policy as well as all other actions required to achieve the Bank’s objectives. Alongside, mechanisms have been set up to ensure that the Bank’s independence is accompanied by accountability and transparency with regard to the executive branch, the legislature and the public. A Council has been created, with the mandate to supervise the orderly and efficient management of the Bank.

B. How Does Israel New IT Framework Compare with That of Peer Countries

7. Israel’s new IT framework is modern, and compares well with the current frameworks of successful “mature” IT central banks in the advanced and emerging market world (Table 1). The key innovations that align Israel’s framework with that of its peers are:

Table 1.

A Comparison of Institutional Frameworks Across Selected IT Central Banks

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Description of framework relates to status quo following the passing of the new Bank of Israel’s law 5770–2010.

But subject to the possibility of a government directive. See section 14 of the Bank of Canada Act. In practice, the government has never exercised its directive power.

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Although the organic law of the central bank establishes three paritarian objectives, the central bank’s Board identifies price stability as its primary objective and financial and currency stability as secondary objectives (see Banco Central de Chile, 2007. « La Política Monetaria del Banco Central de Chile en el Marco de Metas de Inflación »).

Unlegislated. For the UK—with the understanding that inflation expected to deviate from time to time given shocks and with peak effect of policy recognized at 9 quarters.

But horizon can be extended depending on the circumstances.

Financial stability concerns are one of several possible reasons for varying the horizon for returning inflation to target, but do not constitute a secondary objective.

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An “external member” is here defined as a MPC member which is not a staff member of the central bank at the moment of the appointment nor after (although it can have been in the past), and who can hold positions not related to central bank activities during her/his office as a MPC member (some organic laws impose restriction on activity type). (*) The Bank’s governing council operates by consensus. The governing council de facto shares responsibility for monetary policy. However, the Bank of Canada Act formally places responsibility for monetary policy solely in the hands of the governor.

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  1. The new law clearly identifies price stability as the primary objective of policy in line with other successful IT central banks.3 Other goals, notably growth, employment and a reduction of social gaps, as well as financial stability, are secondary objectives. By making low inflation the primary goal of monetary policy and by specifying the goal numerically, the new BoI law makes the Bank’s target intrinsically clearer and more easily observable and understandable than the 1954 law, helping to anchor inflation expectations more effectively.

  2. The inflation forecast over a two-year horizon is the de facto intermediate target of policy.4 Since inflation is partially predetermined in the short term because of existing price and wage contracts and/or indexation to past inflation, monetary policy can only influence expected future inflation. By altering monetary conditions in response to new information, central banks influence expected inflation and bring it in line over time with the inflation target, which eventually leads actual inflation to the target. Contrary to other central banks, in Israel the length of the policy horizon—up to two years—is legislated.

  3. The Bank’s financial stability and foreign exchange rate mandates have been qualified explicitly.5 In line with the organic laws of peer modern IT central banks, the new BoI Law assigns the Bank the goal of supporting the stability and normal functioning of internal and external payments. Importantly, the law also spells out exactly which actions the Bank can take for the discharge of its functions, identifying actions that can be taken under exceptional circumstances; and grants the Governor the right to access at will information to pursue the financial stability mandate from other regulatory authorities in the country.

  4. The new law grants the Bank a considerable degree of independence similarly to other successful inflation-targeting central banks.6 Although the Bank already enjoyed a significant amount of independence in practice, the new law confers the Bank legal autonomy and reaffirms its freedom from fiscal and/or political pressure that would create conflicts with the inflation objective (“institutional independence”). The appointment of a Monetary Committee and a Council, whose members are chosen among the public with no political or business ties (“personal independence”), reinforces the Bank’s institutional independence. Finally, the new law also confers the Bank (and its Monetary Committee) the functional independence necessary to pursue the mandate objectives in a flexible way (operational independence) in recognition of the fact that the target on inflation is typically interpreted as a medium-term goal, and that the Committee has the skills to decide how best to alter the monetary stance so as to keep inflation expectations at target over the medium term (as well as to pursue its other goals).

  5. The Bank is now more accountable than before. As with other successful IT central banks, the new law compensates for the greater operational freedom that IT offers by imposing greater transparency and greater accountability. This includes imposing the frequent and prompt publication of summaries of the Bank’s deliberations and resolutions, quarterly and annual reports, financial reports, as well as explanations of persistent deviations of inflation from target if any.

  6. The Bank’s management and governance have been strengthened.7 Like in other modern IT central banks, the new BoI law institutionalizes a Council the functions of which are supervising the management of the Bank and approving its budget (including the salary terms for Bank employees) and appointing an internal auditor.

C. Does the New Law Reflect the Lessons from the Global Financial Crisis?

8. Following the global financial crisis, significant reforms have been implemented to reflect the change in emphasis at central banks with regard to financial stability. In the United States, for example, the Dodd-Frank Act instituted substantial changes to financial-sector supervision and regulation powers and responsibilities of the Federal Reserve in direct response to the lessons learned from the financial crisis and the associated recession. At the level of the European Union as a whole, a new financial supervisory architecture became operational at the beginning of 2011. It includes three new European supervisory authorities (ESAs) for banking, insurance and securities markets – which aim to strengthen microprudential supervision – and the European Systemic Risk Board (ESRB) responsible for macroprudential oversight. In the United Kingdom, since the 2009 Banking Act, the Bank of England has had a statutory objective to “contribute to protecting and enhancing the stability of the financial systems of the United Kingdom” and the Bank’s Court, consulting HM Treasury and on advice from the Financial Stability Committee, determines the Bank’s strategy in relation to that objective.

9. In this vein, the new BoI Law fully and suitably embeds lessons from the crisis establishing state-of-the-art mechanisms to deal with possible future crises. In particular, the new law:

  • Expands the Bank’s operational toolkit to encompass tools to implement quantitative and qualitative easing. Under the new law, the Monetary Committee has complete autonomy in choosing a combination of policy tools to deal with financial market volatility or distress. To encompass quantitative and qualitative easing tools, the toolkit now includes (in addition to standard measures such as changing the policy interest rate, receiving deposits and granting credit to banks—also by the pledge of securities—issuing directives on reserves held by the banking sector, managing international reserves and intervening in the foreign exchange rate market): (a) perform actions or transactions in the stock exchange, other regulated market or off-market; (b) purchase or sell government paper with maturity over thirteen months; (c) grant credit to non-bank financial institutions. This helps the Bank continue monetary expansion even when the policy rate has reached its effective zero.

  • Emphasizes the Bank’s “Lender of Last Resort” role. Under the new law, the Bank can grant credit to banks determining the conditions for such financing. Importantly, the Bank can now autonomously amend (e.g. loosen) such conditions and extend borrowing to non-bank financial institutions under exceptional circumstances that the Committee believes may threaten the orderly functioning of financial markets.

  • Allows the Bank any action that it deems necessary under exceptional circumstances. These include actions not contemplated in the law itself, preempting the need—in case of future crises—for measures not yet used or conceived but that may possibly become appropriate in circumstances different than historical ones.

  • Confers the Bank the right to gain information on the triggers of capital inflows and outflows. The Governor, with the approval of the Monetary Committee, can now require information on transactions between residents and non-residents in (and/or possession by an Israeli resident of) foreign currency, foreign securities and real estate abroad and in Israel. This allows the Bank to better track the dynamics of such flows, which is helpful in understanding the nature of shocks and designing policies to deal with these.

  • Establishes that the Bank shall be consulted by the government on matters of macro prudential policy relating to capital flows. The Bank can also take an active role in supervising the implementation of such policies. This allows the Bank to coordinate a response to destabilizing flows, which can impact the exchange rate and other asset markets with adverse inflation and growth consequences.

  • Gives the Bank discretion in foreign exchange intervention, permitting unilateral actions in case of urgency. This enhances the Bank’s ability to promptly influence the stance of monetary policy or support the financial system in case of extraordinary foreign exchange rate volatility as can be generated by sudden safe-haven flows during a financial crisis.

  • Enhances policy coordination across governmental agencies and grants the Bank new supervisory and regulatory roles. Via the Governor, the Bank has now been granted the right to access from other Israeli regulatory authorities all information it deems necessary in the discharge of its financial stability mandate. This buttresses policy coordination across regulators and supervisors with beneficial effects on their effectiveness. The new law also allows the Bank to request information and impose financial sanctions to financial institutions not abiding to regulations set by the Bank itself.

D. Options for Development

10. There are areas in the new BoI Law and practice which differ from arrangements elsewhere. Although there is not a present an international best practice on inflation targeting, in some of the areas, arrangements could be aligned over time with potential benefits to the Bank’s effectiveness. Options include:

Objectives:

  • The Committee could gradually start to emphasize the special status of the midpoint of the inflation target range when explaining to the public their interest rate decision. Emphasis on the midpoint would help the public internalize the notion that the Committee preferences relative to the target range are symmetric, that is to say, the Committee is equally uncomfortable to see inflation deviate into the lower and the upper parts of the target range. Importantly, with no emphasis on the midpoint, the range can be perceived as a « range of indifference » which can potentially lead to uncertainty vis-á-vis the exact inflation number at which the Committee aims, delaying the anchoring of expectations at the midpoint as well as potentially increasing inflation volatility by generating inflation uncertainty. Emphasizing a specific number within the range is particular key when a committee—as opposed to a single decision-maker—is in charge of setting the interest rate. Internally, it helps the Committee discuss strategy; while externally, it helps the public and markets extract the substantive reasons behind differences in views among Committee members. This, in turn, helps the public reverse-engineer policies and preferences.8

Accountability:

  • Report inflation (and output growth) forecasts two-years out—in addition to one-year out forecasts. The new BoI Law establishes that the Committee should run policy so that inflation is expected to be within the established price-stability range “within no more than two years”. Showing, as currently done, only inflation and output growth forecasts at a horizon shorter than two years prevents the public from monitoring observance of the inflation target. This not only limits the accountability of the Monetary Committee, but also hinders the swift convergence of inflation expectations at the policy horizon toward the Committee’s belief of where inflation will be at that horizon—blocking one of the main mechanisms through which inflation targeting works.9

Transparency and Communication:

  • The Monetary Committee could start reporting its own inflation and output growth forecasts.10 The Bank’s routine publications only report the Research Department’s forecasts. Although the latter forecasts receive inputs from the Committee, and although the Governor comments publicly on the Research Department’s forecasts during press releases of the Monetary Policy Report, these are not formally the Committee’s forecasts—contrary to international best practice. To guide expectations on interest rates and inflation the public must have clear what is the Committee’s own central tendency outlook on inflation over the policy horizon, as well as know how the Committee apportions risk around its own projection. Having its own forecast would also enhance the Committee accountability vis-à-vis its price stability mandate, and would help rationalize the Committee’s operational decisions regarding other mandates. This does not mean that the Monetary Committee needs to produce an additional set of forecasts to the Research Department ones. Rather, following the example of other successful IT central banks, the Committee could make the Research Department’s forecasts its own over time, by taking a leading role in the choice of initial assumptions—including on shocks—and by applying its own judgment to model forecasts and to the risk skews used in the preparation of the fan charts.

  • Some IT central banks find it useful to share the task of public communication between all members of the Monetary Committee and the BoI may want to consider their example. So far, and in keeping with earlier practice, the Bank’s communication has been executed primarily by the Governor. However, in some IT central banks this is not the case and the task of communication is shared among Committee members so that markets and the public at large—especially where there are no minutes of the policy meetings and/or the votes of individual members are not attributed like in Israel—get to know over time how each member of the Committee thinks and what are her/his policy preferences with respect to current and long-term monetary policy issues. This helps them form expectations with regard to the future course of the policy rate (and thus, inflation) which is decided by the Committee as a whole. However, it is not clear which practice is best, and these arrangements can change over time.

  • Some IT central banks find it helpful to attribute votes in the minutes—a practice the BoI may consider to better reflect the Bank’s new decision-making process. Since the introduction of the new BoI Law, the policy rate is decided by the Monetary Committee and such decision is made on the basis of one-person, one vote. It is not based on a consensus of opinion. In some other successful central banks with a similar set up, like the Bank of England and the Riksbank, for example, the minutes give a full account of the policy discussion, including differences of view. Accordingly, they also record the votes of the individual members of the Committee.

  • Appointments of the members of the Monetary Committee. The new BoI Law establishes a precise and transparent code for the appointment of the members of the Committee. In addition, appointment of the external members is staggered which ensures that the composition of the group of external members of the Committee will change gradually when these members’ appointments expire. In line with some IT central banks, the BoI may want to gradually lengthen the terms of office of external members bringing it to a length equal to that of the Governor and Deputy Governor. The BoI may also want to publicly specify the length of the appointment of the Bank employee appointed by the Governor to be a member of the Monetary Committee, since this is not defined in the new BoI Law or elsewhere at present. Alongside, over time, it should be better clarified what kind of acts unbefit members of the Committee from their status, to limit—in line with some other IT central banks—the potential discretion in removing them from office.

  • The models and the policy rule used to form inflation forecasts could be published more systematically and disseminated widely. The Bank uses a “suite” of models to produce the inflation forecast but these are not well identified in a single document. Importantly, the Bank publications do not explain which interest rate path (or policy rule for the interest rate) are the inflation forecasts conditional upon. Although modeling at the Bank will continue to evolve, it would be important for transparency and accountability to keep the public up-to-date with the Bank’s forecasting technology. This also opens up the Bank’s forecasting to beneficial scrutiny from the academic community domestically and internationally.

Two further areas of the new BoI Law could require particular focus.

  • Handling of information on financial stability matters within the Monetary Committee. Presently, under the new law, the Monetary Committee does not serve as a Banking Supervisory Committee. As a result, the Bank Supervisor reports to the Governor and not the Monetary Committee. However the Monetary Committee does have a role somewhat similar to that of the Financial Stability Committee in the Bank of England—having in the Bank of Israel the role to support financial stability. The access of information by Committee members is currently based on the division of responsibilities. However, there may be circumstances in which making effective decisions in support of financial stability requires knowledge of the confidential information, thereby demanding that all members of the Committee have need for access to that data which is essential to the execution of their mandate. This will be particularly true when systemic issues arise. Without changing the new BoI law, giving information access on financial stability matters under specific circumstances to the Monetary Committee at large could be achieved by amending the Bank Law (which also governs the handling of this information), or, perhaps more easily, by establishing an internal Bank protocol that defines which information will be shared with the Committee by the Governor on an automatic basis.

  • In line with international best practice, decisions on staff salaries should be the remit of the Bank of Israel’s Council alone, with no government role.11 This ensures the Bank’s full budgetary autonomy—which in other successful central banks is a chief tenet of institutional independence. The Bank of Israel needs to be able to recruit and retain skilled staff—a task that is already proving difficult. Finally, to enhance transparency and accountability on Bank’s pay and to maintain appropriate relativities with pay elsewhere in the public and private sectors, Bank’s staff salary determination should be vetted by the Audit Committee; and both the Bank’s remuneration policy and the structure of staff salaries should be made public in the Bank’s Annual Financial Report.

1

Prepared by Nicoletta Batini (nbatini@imf.org).

2

During the 1990s, the Bank of Israel main goal was to facilitate a disinflation process, rather than minimize inflation and output gap volatilities. These became more prominent goals in the 2000s, which may help explain why they were met more closely over that period.

3

Bank of Israel Law 5770-2010, Chapter 2, Art. 3.

4

Bank of Israel Law 5770-2010, Chapter 2, Art. 3.

5

Bank of Israel Law 5770–2010, Chapter 2, Art. 3; Chapter 5, Art. 36–39; Chapter 7, Art. 41–47; Chapters 9, 10, 12 and 13.

6

Bank of Israel Law 5770–2010, Chapter 2, Art. 5; Chapter 3, Art. 11–14; Chapter 4, Art. 15–16.

7

Bank of Israel Law 5770–2010, Chapter 4, Subchapters B and C.

8

The Bank of England shifted from a target range to a point target with range in 1996 on these grounds.

9

See Michael Woodford, 2007. “The Case for Forecast Targeting as a Monetary Policy Strategy.” Journal of Economic Perspectives, 21(4): 3–24. The central banks of the United Kingdom, Sweden, Canada, Chile, and Peru all report inflation forecasts over a two year horizon, a horizon that is long enough to encompass these banks’ individual unlegislated horizons over which transmission is believed empirically to occur.

10

All central banks in Table 1—apart from Israel’s--publish executive boards’ forecasts. As of January 25, 2011 also the FOMC of the Federal Reserve, has begun publishing its own “central-tendency” forecasts (see http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm).

11

For example, in the United Kingdom, the Bank of England Court decides the salaries of senior bank staff including the Governors and External MPC members, while the Governors decide other staff salaries subject to agreement of the Court. In Chile, staff salaries (subject to the private labor code and not the public administration’s) are decided by the Board, while the Board’s salaries are set by a decree after consultation with an external committee of former central bank governors. In Canada, the salaries of the Governor and Senior Deputy Governor are set by the Board of Directors subject to the approval of the federal cabinet. The salaries of other employees of the Bank are set in accordance with the salary scales established by the Board. In Peru, staff salaries are decided by the Board and the Board fixes its own salaries as well as those of senior bank staff, although the President and Congress need to be informed of any change to the salary of the central bank’s president.

Same Series

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Cover IMF Staff Country Reports
Israel: Selected Issues Paper
Author: International Monetary Fund
Volume/Issue:
Volume 2012: Issue 071
Publisher:
International Monetary Fund
ISBN:
9781475502732
ISSN:
1934-7685
Pages:
43
DOI:
https://doi.org/10.5089/9781475502732.002

Israel: Historic Performance Compared

Israel vs. EMEs Performance, 2002–11

Israel vs. Advanced Economies’ Performance, 2002–11