Israeli monetary policy – past and present
Since its creation in 1948, Israel has gone through many turbulent episodes. The Bank of Israel (BOI), which has faced several challenges in recent years, played an important role in them. During the pandemic, it responded to a fall in economic activity through wide-ranging stimulation measures, including foreign exchange interventions against the strengthening of the shekel. It subsequently resisted the inflationary wave, although it had a relatively mild course in comparison with other countries. In 2023, the Israeli economy again found itself under pressure, this time because of judicial reform and, in particular, the start of war with Hamas in October. The central bank immediately responded to the urgent situation and, using targeted measures, helped the war-hit economy to stabilise. This article first looks at the Bank of Israel’s journey to its inflation targeting and describes its current monetary policy. It then focuses on developments in the Israeli economy during the pandemic and the recent inflation wave. Last but not least, it looks at the economic impact of the ongoing war and examines the measures taken by the central bank to stabilise the financial markets and mitigate the immediate effects of the war.
Published in Central bank monitoring – September 2024 (pdf, 698 kB)
Journey from hyperinflation to inflation targeting
Since Israel’s formation in 1948, its economy has faced the impacts of several wars. Particularly significant was the Yom Kippur War in October 1973, which started a period of slow economic growth, high budget deficits and rapidly rising inflation lasting more than a decade. It reached its peak in 1984, when the year-on-year figure was almost 500%. In response to these developments, the Israeli government introduced a comprehensive reform programme (the Economic Stabilisation Plan) at the start of July 1985, including a range of fiscal and monetary measures aimed at stabilising economic trends.[1] Thanks to these steps, year-on-year inflation fell below 20% in the second half of 1986, with only a slight increase in the unemployment rate.
As summarised by Elkayam (2003), the programme included stabilisation of the Israeli shekel, the exchange rate of which was pegged in 1986 to a basket of global currencies in accordance with their shares in foreign trade. The exchange rate therefore became a key nominal anchor in the fight against high inflation. Despite this, inflation remained high in comparison with other countries, which required frequent devaluations of the exchange rate. However, this weakened the exchange rate’s ability to serve as a nominal anchor and led to speculative capital flows. With the aim of increasing the flexibility of the exchange rate, a fluctuation band was introduced in 1989 and was changed to a crawling band in 1992 that enabled gradual depreciation. Together with this, the first inflation target of 14–15% was announced. The importance of the exchange rate as a monetary policy anchor has gradually fallen since then. In 1997, the fluctuation band was significantly expanded, and the Bank of Israel no longer had to keep intervening to defend it.[2] The exchange rate started to be determined by market forces, which meant that the inflation target became the key monetary policy anchor and the interest rate is the main tool for achieving it.
The inflation target fell over time. In some years it was defined as a point target and in others as a target range of one to three percentage points (Bank of Israel, 2007). The gradual reduction of the inflation target was part of the disinflation process and, to a certain extent, represented an opportunistic approach where the announced target for the following year was usually set close to the level of observed inflation at the time the target was set. This meant that gradual disinflation was followed by the gradual reduction of inflation targets, which were mostly set only for the next year. It was not until 2000 that the Israeli government decided in advance on a further reduction of the inflation target for 2001 and 2002, and from 2003 onwards a target range of 1–3% was set for year-on-year changes in the Consumer Price Index (CPI). Since then, there has been ongoing evaluation of compliance with the inflation target every month, in contrast to the earlier evaluation for a whole calendar year.
In March 2008, after a pause of more than ten years, the Bank of Israel again started to intervene to weaken the shekel. The decision was taken as a consequence of its sharp appreciation, unsupported by fundamentals, which started in the second half of 2007. This provided the central bank with an opportunity to increase foreign exchange reserves, whose share of GDP was at a low level. The central bank stated it planned to increase foreign exchange reserves by USD 10 billion over two years through regular purchases with an average volume of USD 25 million per trading day, which was later increased to USD 100 million. The commitment was terminated in August 2009, when foreign exchange reserves reached USD 54 billion (30% of GDP). The central bank remained present on the foreign exchange market, but decided on interventions at its discretion. Another intervention programme was launched in May 2013 to even out appreciation pressures resulting from the start of natural gas extraction. In particular as a consequence of intervention activities, the volume of foreign exchange reserves (external link) increased from USD 29.5 billion in March 2008 to USD 213 billion in December 2021, when they peaked. In relation to GDP in this period, it was an increase in foreign exchange reserves from 15% to 47% of GDP.
Current monetary policy stance
A significant milestone for the central bank’s operations was a new act on the Bank of Israel (external link), which came into force in June 2010. The act defines care for price stability as the BOI’s main task. The other objectives are to support the government’s economic policies, in particular in the area of economic growth, support for employment and reducing social disparities, and to ensure the stability and proper functioning of the financial system. All the secondary objectives are set provided that there is no threat to price stability over time.[3] In accordance with the act, the bank has also had a Monetary Committee, which decides on monetary policy and measures to achieve the central bank’s objectives, since October 2011. The committee has a total of six members – the BOI Governor (who is also the Chair), the Vice Governor and a Governor appointed by the Bank of Israel’s employees. The other three members are external representatives of the professional public who are appointed by the government. Decisions are taken by a majority of votes and, in the event of a tie, the Governor has the casting vote.
An inflation target of 1–3% has been valid from 2003 to the present and the central bank uses a number of tools (external link) to achieve it, where the main tool in the interest rate. Its set level is achieved through open market operations – deposit and credit tenders. As a part of them, the BOI enables banking entities to deposit excess liquidity for a period of one day or one week or to borrow liquidity from the central bank for such periods. In addition to this, the BOI provides a one-day deposit and lending facility, the interest rates of which create a band around the basic interest rate.
The Bank of Israel also issues short-term bonds, MAKAM (external link), which serve to absorb excess funds from the public and steer economic activity, where the principle of their operation can be compared to a short-term bank deposit. These securities are intended for the general public, are issued every month and can be traded on the Tel Aviv stock market. Moreover, their yields serve as an indicator of inflation expectations for a period of up to one year and therefore help decisions about monetary policy.
In addition to these tools, the central bank can use the foreign exchange interventions discussed above, which it has historically engaged in, in particular, to mitigate the negative impacts of a strong shekel on inflation and economic growth. In the past, the BOI also purchased government bonds during extraordinary periods. It made such purchases for the first time during the 2008–2009 financial crisis and then again during the Covid-19 pandemic.
Bank of Israel’s Monetary Policy during the Pandemic[4]
In the pre-Covid period, the Israeli economy was in good condition, but the outbreak of the pandemic shook it badly, just like the rest of the world. Due to measures adopted to stop the infection from spreading, there was a sharp fall in GDP, which was primarily caused by a marked fall in household consumption. Compared to this, exports, in particular in high-tech services, helped mitigate the economic damage. As a consequence of the reduction in economic activity, the price level fell by 0.7% in 2020. The Israeli economy received significant support from both main economic policies – monetary and fiscal. The base interest rate was 0.25% at the start of the crisis, which meant the central bank had only limited scope to stimulate the economy through its main instrument. The Bank of Israel therefore had to use other measures. It first focused on ensuring the proper functioning of the bond market and, for the first time since 2009, started a programme to purchase government bonds, provide the market with liquidity and ease medium- and long-term credit conditions. In April 2020, the BOI reduced the key interest rate from 0.25% to 0.1% and started a programme for providing loans to banks at extraordinarily low interest rates, which was to support lending to small businesses. Subsequently, in July the central bank started, for the first time in its history, a programme for purchasing corporate bonds on the secondary market. During the year, the BOI intervened on the foreign exchange market, to dampen the strengthening of the shekel and prevent its unfavourable impacts on economic activity. The volume of interventions for 2020 reached USD 21.2 billion.
Chart 1 – Trends in key interest rate and inflation in Israel (%, inflation year on year)
Source: Bank of Israel
The rapid revival of economic activity in 2021 enabled the central bank to gradually shutter the extraordinary programmes launched in response to the pandemic. Inflation markedly accelerated from the start of 2021, in particular due to the revival in domestic demand and an increase in global inflationary pressures. However, in an effort to support the economy and in the belief that the rise in price levels was partly driven by temporary factors, the Monetary Committee left the key rate unchanged throughout the year. In addition, the central bank continued to purchase government bonds until the end of the year and continued to intervene against the shekel’s appreciation. The volume of foreign exchange interventions for the whole year reached USD 35 billion (almost 8% of GDP), which was the highest since the BOI’s re-entry to the foreign exchange market in 2008.
In 2022, inflation continued to rise and exceeded 5% in the last quarter. Previous supply and demand inflationary pressures were worsened at the start of the year by problems with energy and food supplies due to the outbreak of war in Ukraine. As a response to inflation trends, the Monetary Committee decided to gradually tighten monetary policy and increased the key interest rate from 0.1% to 3.25% between April and the end of the year.[5] In addition, the central bank was not active on the foreign exchange market for the first time since 2012; the Israeli shekel weakened by around 10% against the US dollar due to purchases of foreign currencies by institutional investors and the growing negative interest rate differential compared to dollar rates.
2023: Inflation returns to target, judicial reform and start of war with Hamas[6]
In the first half of 2023, the BOI continued to increase the base interest rate, which rose to 4.75%. At the start of the year, inflation reached a peak of 5.4% and then started to progressively fall towards the upper boundary of the target range. Israel therefore ranked among the countries that were only moderately affected by higher inflation compared to other OECD countries, primarily thanks to a less marked rise in energy prices. This was the result of higher energy independence, the longer-term fixation of contracts between electricity producers and natural gas suppliers and a temporary fall in excise duties on fuels and coal.
The legislative changes to the judicial system proposed by the government had a significant influence on economic trends in Israel from the start of the last year. Financial markets perceived the reform as a threat to the independence of judicial institutions, which led to an increase in uncertainty and put pressure on a weakening of the Israeli shekel. It weakened by approximately 10% against the US dollar between January and September 2023, which slowed the return of inflation to the target range. Despite this, the Israeli economy experienced a “smooth landing” when in an environment of strict monetary policy, it grew at a moderate pace with gradually falling inflation. In addition, the economy was characterised by a low public debt-to-GDP ratio, high foreign exchange reserves, a surplus on the current account, full employment and a strong high-tech industry.
The turning point of the year was an attack by the terrorist organisation Hamas on Israel on 7 October 2023, which interrupted economic trends, favourable until then. GDP in the fourth quarter fell by 4% year on year (see Chart 2), as a consequence of a sharp fall in investment and private consumption. The war also had an immediate impact on the labour market, as the wide-ranging mobilisation of military reserves, closure of schools and evacuation of people led to a marked fall in labour supply.[7] The construction sector was also significantly affected, with approximately 100,000 Palestinian workers, who account for up to a third of the workforce in construction, unable to enter Israel due to the conflict. The outbreak of the war also led to a sharp increase in tension on Israeli financial markets, which caused a jump in the risk premium and a sell-off of the shekel. The overall response by markets was very negative, even in comparison with previous clashes between Israel and Hamas in the last 20 years.
Chart 2 – Growth in Israel’s real GDP (year-on-year changes in %)
Note: The year-on-year fall in economic activity in the fourth quarter of 2023 as a consequence of the outbreak of war is marked in red. In a quarter-on-quarter comparison, GDP therefore fell by 5.6%.
Source: Trading Economics
The Bank of Israel immediately responded to the situation and, even before the start of the first trading day, announced a plan to sell up to USD 30 billion of foreign reserves[8] with the aim of dampening volatility in the shekel’s exchange rate and ensuring liquidity for the regular operation of markets (in this period the central bank intervened in the opposite – appreciation – direction to that usual in its previous interventions). At the same time, the BOI decided to provide the foreign exchange market with further liquidity through swaps with a volume of USD 15 billion. The weakening of the shekel turned around at the end of October, when it reached its weakest values against the US dollar since March 2015. The shekel then started gradually appreciating and in the second half of November it even strengthened to just under the pre-war level (see Chart 3). This trend was a result of the BOI’s intervention, and in October and November defending the shekel cost it a total of USD 8.5 billion. The calming of the financial markets also had an influence, when they saw that the war would probably not spread to other areas.
Chart 3 – Trends in Israeli shekel/US dollar exchange rate (ILS/USD)
Note: The vertical line indicates the start of Israel’s war with Hamas in October 2023.
Source: Bank of Israel
In addition to measures on the foreign exchange market, the Bank of Israel focused on assistance for businesses and, in cooperation with banks, launched a programme (external link) to alleviate their credit burdens. Pre-defined groups of debtors were enabled to defer the repayment of a loan by three months without an increase in interest and charges. A similar measure was later applied to help credit card holders. With regard to the ongoing war, both programmes were expanded in November to include additional groups of people from the north of Israel. By the end of 2023, the repayment of more than 300,000 loans had been deferred. The bank programme to reduce the loan burden was subsequently extended and expanded to additional debtors in December and March.
The Monetary Committee also activated a repo operations programme in October with the aim of providing shekel liquidity to institutional entities and unit trusts. It was possible to use corporate or government bonds as collateral.
At the start of November, this measure was supplemented (external link) by a targeted programme focused on relaxing loan conditions for small and micro businesses affected by the war with a volume of up to ILS 10 billion (approximately USD 2.6 billion). Companies whose turnover fell as a consequence of the war by 25% or more could therefore obtain bank loans under more favourable conditions. The loans were offered by the central bank against loans that commercial banks provided to affected businesses. The repayment period was set at a maximum of 2 years with a variable interest rate, which was 1.5 percentage points lower than the BOI key interest rate. In November, the programme was expanded to non-bank loan providers and the repayment period was extended to 3 years.
After the start of the war, the Monetary Committee also discussed a possible reduction in the key interest rate, which had remained at 4.75% since May. The sharp fall in economic activity and risk of business failures were good reasons to relax monetary policy. On the other hand, there were fears that a reduction in the interest rate could accelerate inflation as a consequence of the further weakening of the shekel. At the October and November meetings, the Committee decided to focus primarily on stabilising the markets and reducing uncertainty, and left the key interest rate unchanged. In October, the Committee emphasised that monetary policy could focus on supporting economic activity after stability was strengthened on the financial markets and inflation continued to move towards the target band.
Thanks to previously adopted measures, volatility on the financial markets moderated towards the end of 2023. There was also a gradual fall in inflation, and inflationary expectations from various sources indicated that it would return to the target band in the first quarter of 2024. Trends in the shekel’s exchange rate were also positive and after November it appreciated significantly, reaching stronger values than before the outbreak of the war. The Monetary Committee therefore decided at the start of 2024 to reduce interest rates by 0.25 percentage point to 4.5%.
At other meetings from February to August of this year, the Committee left the key interest rate unchanged, in particular because of the growing geopolitical uncertainty. It increased due to adverse developments in the conflict, particularly the involvement of Iran and the extension of the war to the north of Israel, where the Lebanese Hezbollah movement became a threat. The Committee therefore continued with its strategy adopted after the war broke out and concentrated primarily on stabilising financial markets and reducing uncertainty. The decision to keep the interest rate at 4.5% was also due to inflation, which, after a minor slowdown at the start of the year, had been rising since March and had reached 3.2% in July, therefore returning above the target band’s upper boundary.
Ceasefire agreements between Israel and Hamas are still not signed and the end of the war is not in sight. It is now clear that this conflict is of a quite different extent to previous clashes in the last two decades, which means the Israeli economy faces marked challenges. There will probably be a change to the perception of the security situation, which will lead to a marked and permanent increase in the defence budget. There will also be changes on the labour market, where the extension of compulsory military service (external link) will reduce the supply of labour. In addition to this, there could be a long-term increase in the risk premium, which would lead to higher costs of financing government and private investments. On the other hand, wide-ranging investment in military technology could, with regard to the increase in geopolitical tension also in other parts of the world, increase future exports and, on the contrary, support the Israeli economy. The war will certainly also have an impact on other areas, depending on what happens in the future.
Conclusion
The Israeli economy went through a period of hyperinflation during the 1970s and 1980s, which was stopped only thanks to a comprehensive economic reform plan, which included exchange rate stabilisation. In 1992, the Bank of Israel became one of the first central banks that started to execute its monetary policy in an inflation targeting regime. Since 2003, the inflation target has been set at 1–3%. Although the main instrument for its implementation is the key interest rate, the Israeli central bank has historically very often resorted to foreign exchange interventions, to alleviate the negative effects of a strengthening shekel on economic activity.
The last few years were extraordinarily demanding for the Israeli economy. The central bank had to – like the majority of countries in the world – deal with the challenges of the pandemic and the subsequent increase in inflation. The year 2023 brought another difficult test for the economy, as it first faced increased uncertainty as a result of the government’s proposed judicial reform, and later in October a conflict erupted in what became an event unprecedented in the last twenty years. At the beginning, the war had a strong negative impact on economic activity, in particular the labour market, increased geopolitical tension and led to a sell-off of the shekel. The Bank of Israel immediately responded by launching foreign exchange interventions to mitigate exchange rate volatility and introduced targeted programmes to support affected households and small business. In its decisions, it focused primarily on stabilising markets and reducing uncertainty. The immediate impacts of the conflict were mitigated during the first months, partly thanks to the monetary policy and other stabilisation measures adopted. However, the war is still ongoing and, despite some improvement in macroeconomic trends, the Israeli economy and society have a long journey to return to normal functioning.
Literature
Bank of Israel (2007): “Inflation Targeting Revisited”, Bank of Israel, 3-7. (external link)
Elkayam, D. (2003): “The Long Road from Adjustable Peg to Flexible Exchange Rate Regimes: The Case of Israel”, Bank of Israel Working Papers 2003.04, Bank of Israel, 4-21. (external link)
Kreis, E. S. (1989): “The Inflationary Process in Israel, Fiscal Policy, and the Economic Stabilization Plan of July 1985”, International Monetary Fund. (external link)
[1] For more details on the causes of hyperinflation and the stabilisation measures see, for example, Kreis (1989).
[2] The exchange rate fluctuation band was formally cancelled (external link) in June 2005. Until then, it had been gradually expanded and had become so wide that the Bank of Israel did not have to intervene to defend it, so the band stopped being important.
[3] “Price stability over time” means a situation in which the Monetary Committee, based on the monetary policy stance, expects the inflation rate to remain in the target range or to return to it within a period not longer than two years. The inflation target is determined by the Israeli government after consultation with the central bank Governor.
[4] The following part of the text is based on annual reports (external link) issued by the Bank of Israel for 2020–2022.
[5] Year-on-year inflation was above the upper boundary of the 1–3% target range from January 2022, but the Monetary Committee raised the interest rate for the first time in April 2022. There were several reasons for this. At the start of the year, the Committee assessed that the economy had not yet fully recovered from the pandemic. The coronavirus variant omicron was spreading in Israel at this time and could have caused a fall in economic activity in the first quarter. Another reason was the belief that the increase in inflation was only temporary, caused by failures in global supply chains and growth in commodity prices. Last but not least, there were fears that an increase in the interest rate before key central banks (in particular the US Fed) also did so could lead to undesirable appreciation of the shekel.
[6] The text about the events from 2023 and 2024 draws on the Bank of Israel Annual Report 2023 (external link) and Monetary Policy Report First Half of 2024 (external link).
[7] Approximately five weeks after the outbreak of the conflict, the Bank of Israel’s research department tried to calculate the conflict’s impacts on the supply side of the labour market. In the analysis (external link), they estimated that the costs arising due to the absence of workers would reach up to ILS 2.3 billion a week (approximately 6% of weekly GDP).
[8] At the end of September 2023, the volume of foreign exchange reserves was almost USD 200 billion, which corresponded to 38.1% of Israeli GDP.