Leumi Economic Weekly

The exchange rate of the shekel vis-à-vis the US dollar fluctuated over the past year within a very narrow range…
In our review last week we noted, within the context of the increasing portfolio inflows from foreign investors, that it is possible foreigners’ expectations regarding the shekel’s exchange rate take into consideration also the Bank of Israel’s (BoI) intervention in foreign exchange trading. Possible support for this claim can be seen by looking at the accompanying graph, which presents the development of the exchange rate of the shekel vis-à-vis the dollar over the last five years. As can be seen in the graph, until approximately one year ago, the exchange rate of the shekel vis-à-vis the dollar fluctuated within a wide range, while more recently over the past year it fluctuated within a very narrow band.

An additional expression of this can be found in standard deviation data implied from the shekel/foreign currencies options market, according to which the standard deviation, which amounted to 15% a year ago, is currently at only 7%. This recent stability in the exchange rate of the shekel vis-à-vis the dollar exists despite the fact that in global markets, which impact the local market, much higher volatility exists. For example in the dollar/euro market over the past year the exchange rate fluctuated within a range of more than +/-10% above the average exchange rate for the period.

…the narrow trading range of the exchange rate – a result of action by the BoI in the market

This unofficial effective narrow trading range is not the result of “the free market”, but instead stems for the most part from the intervention of the BoI in foreign currency trading since the financial crisis began to accelerate some two years ago. The desire to prevent an appreciation in the exchange rate of the shekel and in this manner to support Israeli exports, led the central bank to purchase large quantities of foreign exchange, as can be seen in the accompanying graph.

Even when the central bank ceased to intervene in the foreign exchange market on a regular basis but instead acted only when the bank saw a need for intervention, the understanding of these new “rules of the game”, according to which the market is not fully free, apparently impacted the expectations of market “players” and moderated volatility. This process makes it easier for investors to act in the short-term and to achieve profits stemming from the interest rate differentials between the shekel interest rate and rates overseas, in particular on the dollar.

The problem with this process is the potential for it to take on much greater dimensions, on its various costs, in particular if the interest rate differential will widen further or even to surprisingly change direction, a situation that could occur quite suddenly. The basic question standing in the background is whether or not it is correct for the BoI to continue to try to pursue several different goals at the same time by using a single policy instrument (the interest rate). The targets pursued being, among several, the price stability target and maintaining a degree of export competitiveness. A different mixture of policy measures (monetary and fiscal) would reduce the need of the BoI to act in the foreign exchange market and consequently would reduce the risks involved in the central bank’s continued intervention in this market.

Wages in the economy continue to recover

An upward trend in real wages for salaried positions was seen in the first five months of the year. Despite the high volatility in the rate of change in wages (also when neutralizing the impact of seasonality), we see that after falls of 5-6% in the annualized rate throughout 2009 (see graph), a substantial correction was recorded and the current annualized rate amounts to 1-2%. This correction reflects the labor market’s recovery: trend data from the Central Bureau of Statistics (CBS) indicate a fall in the unemployment rate to 6.5% in May, and from the published report on the BoI’s monetary discussion prior to the last interest rate decision, it can be learned the central bank also estimates the fast recovery rate of the labor market returned in the second quarter of the year.

Against this backdrop we estimate that in the coming year the rate of increase in real wages of 1-2% will continue, similar to the rate of change during the years 2006-2007, prior to the financial crisis.