A rift between Israel’s government and central bank over Finance Minister Yuval Steinitz’s decision to double the budget deficit target next year could worsen if higher state spending prompts the central bank to raise interest rates.
Bank of Israel Governor Stanley Fischer has already warned that rates may have to rise as a result of the change. Budget expansion is typically inflationary, and Fischer fears additional pressure on government finances should the crisis in the euro zone, Israel’s biggest trading partner, intensify.
Israel’s economy is slowing from growth of 4.8 percent in 2011 to an expected 3 percent this year while the government has committed to higher spending on wage agreements and other deals after popular protests last year over high living costs.
Analysts said the dispute could end a period of relative harmony in historically fraught relations between the government and central bank following Fischer’s appointment to the central bank in 2005, and coinciding with an economic boom.
“What we are seeing now is a return to the Israeli-type of normality which we knew from the ‘90s and the previous decade,” said Bank Leumi Chief Economist Gil Bufman.
Finance ministers in the 1990s battled then-governor Jacob Frenkel as he sought to slash inflation from 20 percent, liberalize the foreign exchange market and ease foreign capital flows. Frenkel sharply raised interest rates, which led to high unemployment and public anger.
His successor David Klein and Finance Minister Silvan Shalom meanwhile clashed over fiscal policies in the early 2000s.
Prime Minister Benjamin Netanyahu backed the rise in the 2013 budget deficit target to 3 percent of gross domestic product from 1.5 percent, which was approved in cabinet on Sunday. Steinitz has yet to give details of the budget.
The Bank of Israel had sought a 2.5 percent target.
“There’s been a lot tension since the minister decided on 3 percent,” said a spokeswoman for Steinitz. “Stanley (Fischer) wasn’t too happy about it ... It’s hard to argue with Fischer given all the professional knowledge he has.”
Fischer, a distinguished academic economist nominated to lead the central bank by then-finance minister Netanyahu, was Federal Reserve Chairman Ben Bernanke’s thesis adviser.
The spokeswoman said Fischer had tried to change ministers’ minds before Sunday’s cabinet vote.
“I am sure this will pass,” she said of the rift. The Bank of Israel declined to comment.
Israel is not the only country where the central bank and government do not see eye to eye. A disputed law in Hungary that was seen as threatening central bank independence has held up its international aid talks for more than seven months.
“Normally, central banks and governments do get along but it’s not uncommon for the central bank to say (to the government) that you have to lower the fiscal deficit or we will have to tighten monetary policy,” said Daniel Hewitt, an economist at Barclays Capital. “That’s a very common statement.”
“It’s not personal”
Klein, Fischer’s predecessor, said the disagreement between the Bank of Israel and the Finance Ministry was not a big issue.
“You have to take it as a debate between policymakers,” Klein told Reuters. “It’s not personal, and for the time being this is what it looks like.”
Klein called the current debate an “academic discussion” but said much depends on whether Israel will be able to stick to its new targets. “If a more pessimistic outlook materializes, then there might be a problem,” he said.
Economists say Israel will find it tough to meet even a 3 percent deficit target next year. A slowing economy is likely to depress tax revenues, while the general election to be held in October 2013 may encourage spending commitments and make the government reluctant to hike or introduce taxes.
Netanyahu has said he opposes tax increases since they harm growth, while Steinitz argues that supporting economic growth is paramount, noting that most other Western countries have deficit targets far higher than 3 percent of GDP.
Israel’s fiscal policy has already been loosened, with a budget deficit of 3.5-4 percent of GDP expected this year, well in excess of the 2 percent target. Fischer has long sought tax hikes to rein in the deficit.
The Bank of Israel resumed lowering short-term interest rates last week after four months on hold due to fears that the global economic slowdown ─ especially the crisis in Europe ─ would harm Israeli growth.
“If the Bank of Israel comes back and cuts rates (again) it’s a bit like crying wolf,” said Richard Fox, senior director for sovereign ratings at Fitch Ratings.
Economists had forecast the central bank would lower its benchmark rate once more in the near term, to 2 percent from 2.25 percent, to support growth.
Now, some believe the Bank of Israel will stay on hold for an extended period due to the concerns of fiscal loosening.
“He (Fischer) is not going to raise interest rates. That’s an empty threat,” said Mike Astrachan, an independent economist.