The interest gap is closing

With the US Federal Reserve interest rate down to 0-0.25%, there is little room left for maneuver for interest rate policy in the US, to help revive the American economy. In Israel, on the other hand, with interest holding at 1.75%, there was still a way to go. However, on 26 January, the Bank of Israel announced its decision to reduce interest further – to 1%, thus narrowing the interest gap between the US and Israel. Will it be narrowed further? We will have to wait a month to see.

This is the 6th interest reduction in Israel since September 2008, when interest stood at 4.25%: at the same time, the US Fed interest rate was a much lower 2%. The recent process of interest rate reduction has therefore been much more dramatic in Israel than in the US: since September, interest in Israel has fallen by 3.25% (from 4.25% to the current 1%) while in the US, the reduction has been 1.75-2%. So the narrowing of the interest gap between Israel and the US has been going on now for several months.

The concern in Israel – and the rationale for the interest rate reductions – has been the same as in the US: the slowdown in the economy and the strong possibility that the slowdown will turn into a recession (a period of negative GDP growth). This is already accepted in the US but now it is also accepted by the Bank of Israel. In July 2008, the Bank published a forecast of 3.4% growth in 2009. This was reduced to 3.1% in August, to 2.7% in October and to 1.5% in November.

Just one day before its most recent interest rate decision, the Bank published is latest 2009 growth forecast according to which the Israeli economy will be in recession in 2009, with negative growth of -0.2% (see our blog of 14 January – "Growth forecasts for 2009 keep getting reduced"). The performance of the economy in 2009 may well turn out to be even worse than this.

Will the interest rate reductions work, helping to revive the Israeli economy? In the press statement that accompanied the reduction of interest to 1%, the Bank of Israel complained – not for the first time – that interest rate reductions by the central bank since September have not been followed by similar reductions implemented by the commercial banking sector and that the commercial banks have not eased up on the credit crunch.

This of course is what has to happen if the reduction in interest is to work. The central bank cannot force the commercial banks to lower interest when it lowers interest, but in the past, commercial interest has generally followed central bank interest closely. The commercial banks argue that since interest payments constitute a major part of their income, lowering interest too much could jeopardize their stability.

However much the Bank of Israel would want to avoid this possibility (especially in view of the collapse of major banks in the US and elsewhere), the banks' argument is not regarded as satisfactory by the Bank of Israel. The counter argument is that it is in the commercial banks' own interest to do everything possible to help revive the economy.

Central bank Governor Stanley Fischer announced that if the commercial banks do not come through of their own volition and lower interest, he will have no choice but to implement (perhaps regulatory) measures to make them do so. Everyone is now waiting to see what these measures could be.