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Shocks and Currents: Monetary Policy and Israel’s Foreign Exchange Market

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Abstract

This paper explores the interplay between domestic and global monetary policies, capital flows, and exchange rate dynamics in Israel. Using a novel dataset of daily sectoral FX transactions, we examine the transmission of monetary shocks identified from yield curve shifts around central bank announcements. Local projections reveal that foreign financial investors respond strongly and symmetrically to domestic and foreign shocks, which suggests that they react to the interest rate differential. Domestic institutional investors counteract this by rebalancing their portfolios. In particular, the impact of US monetary shocks on Israeli institutional investors and on the exchange rate depends on the shocks’ correlation with the S&P 500 stock index. The findings contribute to a deeper understanding of the mechanisms through which domestic and global monetary policies influence small open economies like Israel, and highlight the limited monetary autonomy of small open economies even under flexible exchange rates.

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Notes

  1. See also Swanson (2023).

  2. In the period following the October 7th 2023 events and the war in Gaza (which is outside our sample), the Bank of Israel sold foreign exchange for the first time to counteract short-term disruptions in the FX market.

  3. See also Matheson and Stavrev (2014).

  4. This section draws heavily from the analysis and survey presented in Barkai and Liviatan (2007).

  5. See Fischer (1987) and Patinkin (1993).

  6. For dependent variables expressed as flows, the cumulative change \({\Delta }_{h}{y}_{t+h}\) represents the accumulated flow over the period from time \(t-1\) to time \(t+h\).

  7. In Appendix, we present the results for the 3-month yield, which are qualitatively similar to those obtained for the 1-year yields.

  8. Kutai (2023) analyzed the effect of BOI forward guidance using intraday data but his sample is partial.

  9. In the USA, we use the benchmarks provided by Bloomberg for the corresponding bills and T-bonds. In Israel, we use interbank rates up to maturity of 1-year (TELBOR) and the Benchmarks for Government Bonds for longer maturities. As the TELBOR day is fixed daily by the BOI at noon and the policy announcements of the BOI are released at 16:00, we use the change between the day following the announcement (\(t+1\)) and the day of announcement (\(t\)) in order to measure the shifts in maturities of up to one year. As government bonds in Israel are traded in the stock exchange, which closes at 17:30, we use the shift between day of announcement (\(t\)) and the previous day (\(t-1\)) in order to measure the shifts of yields longer than one year. This differential treatment is applied because the money market in Israel is not deep and liquid, and therefore the yields are noisy and unreliable.

  10. If we consider \(k\) to be 0, then the \(\mathbf{Z}\) can be comprehensively represented by \(n\) separate white noise processes. In a case where \(k\) equals 1, \(\mathbf{Z}\) would be described as a linear response to a single factor and an uncorrelated white noise. If we consider \(k\) to be 2, \(\mathbf{X}\) would be seen as a response to two intrinsic dimensions of BOI announcements, again complemented by uncorrelated white noise, etc.

  11. This interpretation is related to the level and slope interpretation common in finance models such as the Nelson-Siegel model.

  12. All FX transactions—onshore and offshore—are reported to the BOI’s statistics department on Coordinated Universal Time (UTC) basis. This creates some discrepancy in the local “day” definition between US (UTC—5, EST) and Israel (UTC + 2), but this takes place after main business hours in both countries. We match the flow data with Bloomberg COB USDILS rate sampled at 23:00 local time. The data are confidential, as they include FX transactions by the BOI on a daily basis while the BOI reports to the public only on a monthly basis.

  13. The statistics for the BOI intervention refer to all trading days, including a large share of days with no intervention.

  14. We do not include lagged shocks on the RHS of the estimation as they are always zero on the days prior to the interest rate announcement.

  15. With a positive value indicating a depreciation of the ILS.

  16. The results for the 3-month yields are presented in Appendix and are qualitatively similar.

  17. Institutional investors regularly use future contracts on the S&P 500 index in order to rebalance their portfolios.

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Acknowledgements

We express our gratitude to participants in the Bank of Israel Research Department Seminar and in the “50 Years after the End of Bretton Woods—The Experiences of Small Open Economies” workshop in ETH Zurich. The views presented in this paper are exclusively those of the authors. They do not necessarily represent the views of the Bank of Israel or any of its staff.

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Authors and Affiliations

  1. Research Department, Bank of Israel, Jerusalem, Israel

    Itamar Caspi & Sigal Ribon

  2. Markets Department, Bank of Israel, Jerusalem, Israel

    Amit Friedman

Authors
  1. Itamar Caspi
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  2. Amit Friedman
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  3. Sigal Ribon
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Correspondence to Amit Friedman.

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Appendix

Appendix

See Table

Table 4 Yields statistics 2010–August 2023, decision dates
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4, Figs.

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a The reaction of capital flows and the exchange rate to a 100b.p. Shock to the 3-month US Yield. b The reaction of capital flows and the exchange rate to a 100b.p. Shock to the 3-month local yield. The gray lines depict a 90% confidence interval corrected for possible autocorrelation using Newey–West procedure. Flows are in $billions; positive figures represent outflows. ddol is the percentage change in the ILS/USD rate, and a positive figure represents depreciation of local currency. (Color figure online)

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10 and

Fig. 11
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a The reaction of capital flows and the exchange rate to a 100b.p. Shock to the 1-year US Yield, 2010–2019. b The reaction of capital flows and the exchange rate to a 100b.p. Shock to the 1-year local yield, 2010–2019. The gray lines depict a 90% confidence interval corrected for possible autocorrelation using Newey–West procedure. Flows are in $billions; positive figures represent outflows. ddol is the percentage change in the ILS/USD rate, and a positive figure represents depreciation of local currency. (Color figure online)

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11.

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Caspi, I., Friedman, A. & Ribon, S. Shocks and Currents: Monetary Policy and Israel’s Foreign Exchange Market. Comp Econ Stud (2024). https://doi.org/10.1057/s41294-024-00236-y

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