Israel Gets Surgical in Fight Against Deflation

Other central banks might follow a similar dual interest rate path.

Negative interest rates seemed like a great idea at the time. Central banks would effectively pay commercial banks to borrow money from it by “charging” a negative interest rate, and it was thought that the commercial banks would then be more able to lend to businesses at more favorable terms. The problem is that commercial banks charge interest rates commensurate with the level of risk they are taking in lending to enterprises, and so many business loan rates remain relatively high, especially as the economy tanks and bankruptcies are rising. Negative (or zero %) interest rates could also have the opposite of the desired effect by effectively encouraging business and individuals to save even more because their cash at the bank is earning nothing. Because of this, central banks are increasingly wary of going down the negative interest rate path.

Enter the Bank of Israel (BoI). Israel has been struggling with bouts of consumer price deflation for years, as the chart below shows, and after crashing by 34% this year, the Tel Aviv stock exchange index still languishes some 19% below its peak. Israel’s private sector debt amounts to around 110% of its Gross Domestic Product. The BoI has now launched an initiative whereby, although its official interest rate remains above zero, at 0.10%, it is offering negative interest rates to commercial banks in specific circumstances. The loans must be used to help give credit to small businesses and, crucially, the BoI is capping the rate that commercial banks can charge to those enterprises.

This is a new path for free-economy central banks, essentially mandating how private sector banks operate, and is sign of how increasingly desperate central banks are in their futile fight against deflationary forces. Why would commercial banks use this scheme, where they are being told what (lower-than-normal) reward to accept, when they carry all the risk if the borrower fails?

Nevertheless, some think it’s a good idea. According to a Bloomberg report, Megan Greene, a senior fellow at Harvard’s Kennedy School of Government thinks that it’s, “…a really important innovation that other central banks should adopt.” Should that view catch hold, governments and central banks will be going a long way in crowding out the private sector.