Israel: Central Bank Independence Under Threat?

There is an old debate in Israel on the role of monetary policy in contributing to a recovery in output, and it has generally taken place against the background of two differing visions of central bank independence. Late in 1998 the Levine Committee, a government-appointed panel charged with the task of reviewing the Bank of Israel Law, presented its recommendations to the government under Prime Minister Benjamin Netanyahu. The essence of these was to buttress central bank independence by formally and unambiguously incorporating price stability as the primary goal of the Bank of Israel, and to broaden the responsibility for the implementation of monetary policy, which presently rests solely with the governor, through the appointment of a five-member Monetary Committee, three of whose members would be appointed by the government in consultation with the governor to serve for five-year terms.

An alternative vision of central bank independence was given a significant boost in late 1998, when an opposition-backed draft to amend the Bank of Israel Law cleared the Knesset Finance Committee and was actually passed on first reading by the full Knesset in early 1999. This draft did not unambiguously identify price stability as the primary goal of the Bank and called for the creation of a Board, akin to a governing council, that would have overall responsibility for monetary policy and whose members could, in principle, be drawn fr om a variety of constituencies, including possibly private sector representatives. Underlying these proposals was the notion that the Bank of Israel had been unduly focused on inflation control, and had not been sufficiently sensitive to the weakening of output seen in the second half of the 1990s and the concomitant rise in unemployment.

The Levine Committee’s recommendations were never formally discussed by the government. Ehud Barak became prime minister in the summer of 1999 and soon thereafter the focus of policymakers’ attention shifted to security issues, initially in the context of the Camp David negotiations and, subsequently, the consequences of their failure. The present government has decided to proceed ahead with amendments to the Bank of Israel Law and specific proposals are expected to be discussed by the Cabinet on 17 March. The essence of these proposals differ fr om the spirit of the Levine Committee recommendations in a number of respects. First, they do not unambiguously make price stability the primary goal of the Bank. Instead, the idea seems to be to move to a regime in which the goal of long-term price stability is at times constrained by the need to pursue other policy objectives set by the government: for example, encouraging employment creation or boosting potential GDP.

The government also proposes to create a nine-member Board with overall responsibility for monetary policy; in addition to the Governor and his/her two deputies, there would be an additional six appointees proposed by the Ministry of Finance. Although these are expected to have relevant experience, the door appears to be left open for the possible appointment of officials on the government payroll. Another proposal puts forward the notion that the Bank would no longer manage the international reserves; rather, its role would be closer to that of an “agent,” charged with the implementation of the government’s FX management objectives – a significant departure fr om existing practice, wh ere the Bank has direct responsibility for reserve management.

These draft proposals have raised a number of concerns in the market, the consequences of which the authorities will have to ponder seriously as the legislative process moves forward. First, there is skepticism about the wisdom of an institutional regime in which the interest rate, the Bank’s single policy tool, is aimed at a variety of shifting objectives. The overwhelming market view is that the primary aim of monetary policy should be to achieve sustained price stability, leaving to structural and fiscal policies the task of dealing with rigidities and supply constraints which, for instance, might be preventing greater job creation, or the emergence of a more efficient economy-wide allocation of resources. There is ample theoretical and empirical evidence for the thesis that monetary policy in the context of a flexible exchange rate regime works best when, given certain inflation expectations, the authorities do not yield to the temptation of accelerating money growth in the hope of stimulating output, and monetary policy is not held captive to pressures stemming from the need to finance large fiscal deficits and/or large wage increases.

Furthermore, while reaching consensus within a central bank board on the actual implementation of monetary policy can be difficult, even in those cases wh ere the focus is overwhelmingly on price stability, it is likely to be more so in situations wh ere different board members may have a range of views as to what should constitute the top policy priority of the moment. (Cynics argue that, to forestall this, the government’s six direct appointees could be chosen not for their intellectual independence and impeccable credentials, but rather for their willingness to defend and vote for a particular government line.) The potential politicisation of monetary policy that might result from such arrangements could go a long way toward undermining the hard-won recognition earned in the past few years for the authorities’ generally cautious macroeconomic management.

Second, the market would be greatly concerned about the government taking a high-profile role in the area of reserve management. De facto, this could push the government into day-to-day exchange rate management, raising questions about potential conflicts of interest in policy implementation. Third, and most importantly, if carried out, these proposals have the potential seriously to weaken the one and only effective anchor in the Israeli economy during the last several years: a credibly independent monetary policy. One of the key achievements of the last couple of years has been the growing resilience of price expectations and the exchange rate to a variety of shocks - major domestic political changes, the collapse of the global high-tech sector, the deterioration of the security situation, the overshooting of budget deficit targets - any of which in the past would have destabilised financial markets in tangible ways. Throughout these difficult times, the Bank of Israel has been perceived by the market as having been successful in the implementation of inflation-targeting even if, in an uncertain environment and like other central banks similarly engaged, it may have occasionally erred on the side of caution.

Although the present proposals have yet to get a full airing in the Knesset and it remains to be seen what a broad-ranging debate on their underlying merits is likely to bring, we are concerned that the focus of policy discussions is likely to shift to issues which have long been debated in Israel (eg, is the economic recovery being held hostage to “unduly tough monetary policies”?) and the utility of which has been questionable at best. A far more productive policy debate would focus instead on the kinds of policy reforms necessary to enhance the economy’s long-run (potential) growth rate - tax reform, expenditure restructuring, a thorough review of the social benefits system, privatisation, to name a few. Failure to move aggressively on this front during the last couple of years has not worried the markets excessively because there has been recognition that the authorities were understandably focused on security-related issues and dealing with the impact of the international recession.

Shifting the policy focus to undermining central bank independence is not likely to enhance the credibility of the government – indeed, if aggressively pursued, it could do to the shekel what 18 months of intifada have so far failed to do.