Daniel sent us this one — and it's a good one. He says we've talked about what central banks are and we've talked about exchange rates, but now he wants us to connect the two. Specifically, when a central bank says it might intervene in a foreign exchange market, what does that actually mean? And he zeroes in on the interest rate as the main lever — what is this rate, how does it flow through the economy, and what is all that pondering about a few basis points actually doing for those of us without economics degrees?
The interest rate question is the right place to start, because it's the thing people hear about constantly and also the thing most coverage explains terribly. The central interest rate, the policy rate — in Israel the Bank of Israel calls it the policy rate, the Fed calls it the federal funds rate — it is fundamentally a target for what banks charge each other for overnight loans.
Overnight loans between banks.
At the end of every business day, some banks have more reserves than they need and some have less. The ones with a shortfall borrow from the ones with a surplus, and the interest rate on that borrowing is the interbank rate. The central bank sets a target for that rate and then uses its tools to push the market toward that target.
The central bank isn't actually setting the rate — it's setting a target and then muscling the market toward it.
And that distinction matters. The Bank of Israel's monetary committee meets eight times a year to decide on the policy rate. When they announced in late February 2025 that they were holding the rate at four point five percent, they weren't decreeing a number that all banks must use. They were saying: we will conduct operations so that the rate banks charge each other for overnight loans lands at four point five percent.
That rate then becomes the anchor for everything else.
It ripples outward. The interbank rate becomes the reference for the prime rate that commercial banks charge their best customers. Mortgage rates, business loan rates, credit card rates, the yield on government bonds — they all price off this anchor. If the policy rate moves up by twenty-five basis points, a variable-rate mortgage might adjust upward by roughly the same amount within weeks. That's the transmission mechanism.
When the Bank of Israel held at four point five, they were essentially saying: credit in this economy costs four and a half percent at the base level, and everything else prices from there.
Compare that to where things were. In April 2020, at the height of COVID, the Bank of Israel cut the rate to zero point one percent. Zero point one. That was emergency-level cheap money. They held it there until April 2022, when inflation started showing up globally, and then they began hiking. By May 2023 they were at four point seven five percent. Now they've settled at four point five.
That's a pretty dramatic swing in the cost of money over a few years. If you took out a mortgage in 2021 versus 2024, you're living in completely different financial realities.
That's exactly the kind of thing the central bank is trying to manage — not just the level, but the pace of change, because sudden shifts create winners and losers in ways that can destabilize the whole system.
Which brings us to the second part of the question. Daniel mentioned that the Bank of Israel commented on the shekel's strength and said they don't plan on intervening. What would intervention actually look like if they did?
There are two main channels. The first is direct intervention in foreign exchange markets — the central bank literally buys or sells foreign currency to move the exchange rate. The Bank of Israel has done this extensively. Between 2008 and 2021, they ran a foreign exchange purchase program to moderate shekel appreciation, and they accumulated over two hundred billion dollars in reserves doing it. That's a massive balance sheet operation.
Two hundred billion dollars. For a country of ten million people.
It tells you how serious the shekel's appreciation pressure has been. Israel runs persistent current account surpluses — it exports more than it imports, particularly in high-value services and tech. That creates a structural inflow of foreign currency that pushes the shekel up. The Bank of Israel was buying dollars to lean against that tide.
They announced a shift in early 2025. Governor Amir Yaron said the bank would no longer intervene in the foreign exchange market to moderate shekel strength, and instead would let the exchange rate float more freely. The rationale was that the shekel's appreciation reflected real economic fundamentals — the tech sector, the gas exports, the strong external position — and fighting those fundamentals with intervention was becoming counterproductive.
When the shekel hit two point nine to the dollar, and exporters started feeling the squeeze, the central bank's position was essentially: this is the real exchange rate, and we're not going to artificially weaken it.
That's a defensible position, because direct FX intervention has limits. You're buying foreign currency with newly created shekels, which expands the money supply, which can be inflationary. You're also taking on exchange rate risk — if the shekel keeps strengthening, those dollar reserves lose value in shekel terms. The Bank of Israel actually took heat for this; there were years where the valuation losses on their FX reserves showed up in their financial statements.
Direct intervention is expensive, risky, and fights against fundamentals. That's why the interest rate becomes the cleaner tool.
That's the second channel. Instead of buying dollars directly, you adjust the interest rate to change the incentives for holding shekels versus dollars. This is the mechanism Daniel was asking about. When the Bank of Israel raises its policy rate relative to the Federal Reserve's rate, holding shekel-denominated assets becomes more attractive because you earn a higher yield. Capital flows in, demand for shekels increases, and the currency strengthens.
Which sounds like the opposite of what you'd want if you're worried about an overly strong shekel.
If the shekel is too strong and you want to weaken it, you'd cut rates. Lower rates make shekel assets less attractive, capital flows out, the currency weakens. But here's the tension — you can't set interest rates for the exchange rate alone. The primary mandate of the Bank of Israel, like most central banks, is price stability. If inflation is running above target, you need higher rates to cool the economy, even if those higher rates strengthen the currency further and hurt exporters.
The central bank is juggling at least three things at once. Inflation, which it's mandated to control. The exchange rate, which affects trade competitiveness. And financial stability, because rate changes ripple through the entire banking system.
In Israel's case, there's a fourth dimension — housing prices. The Bank of Israel has been explicit that the housing market factors into their rate decisions. When rates were at zero point one percent, mortgage lending exploded and home prices surged. The rate hikes since 2022 were partly aimed at cooling that.
It's like trying to tune a car engine while driving on a winding road with four different passengers all shouting directions.
That's not a bad analogy. And the thing about the interest rate is that it's a blunt instrument. When you raise rates, you don't get to say "this is for inflation, not for mortgages, and definitely not for the exchange rate." It hits everything. Every borrower in the economy feels it. Businesses delay investment. Households cut spending. The construction sector slows down. It's a sledgehammer, not a scalpel.
Which makes the deliberation over a few basis points make more sense. If the tool is that blunt, twenty-five basis points is a genuinely meaningful move.
A twenty-five basis point increase on a mortgage of one and a half million shekels can add hundreds of shekels to a monthly payment. Multiplied across an entire economy, that's a significant demand shift. The central bank is trying to calibrate: enough to cool inflation, not enough to crash the economy, and hopefully not so much that the currency strengthens to the point where exporters can't compete.
Let me pull on the thread of how this actually works in practice. Daniel mentioned the multi-tier system in Europe versus the single tier in Israel. Walk me through that difference, because it affects how rate decisions actually transmit.
The European Central Bank sets the policy rate for the eurozone, but it doesn't lend directly to businesses or households. The national central banks — the Bundesbank, the Banque de France, the Bank of Italy — they're the ones that actually implement monetary policy in their countries. They run the payment systems, they lend to commercial banks, they're the operational arm. The ECB sets the rate, the national banks execute.
It's like the ECB is the brain and the national banks are the hands.
And that creates complications. A single interest rate for nineteen different economies, each with its own inflation rate, its own fiscal position, its own housing market. The rate that's appropriate for Germany might be too tight for Italy or too loose for Ireland. That's the structural tension in a currency union.
Israel doesn't have that problem because there's only one economy to worry about.
One economy, one central bank, one policy rate. The Bank of Israel's monetary committee has six members — the governor, the deputy governor, and four external members appointed by the government. They meet, they look at the data, they vote. The decision applies uniformly. There's no Bundesbank to mediate or interpret.
Which should make policy more responsive, in theory.
It does, and we see it in the data. The Bank of Israel was one of the first central banks globally to start hiking in 2022. They moved early and aggressively. By contrast, the ECB was slower to move because it had to build consensus across a much more complex political economy.
What about the Fed? Daniel mentioned the disproportionate global significance of the dollar.
The Fed's rate decisions matter far beyond US borders. When the Fed raises rates, it strengthens the dollar globally, which tightens financial conditions in emerging markets because their dollar-denominated debt becomes more expensive to service. Central banks around the world effectively have to factor the Fed's decisions into their own rate-setting. If the Fed is hiking and you're cutting, your currency weakens, which can import inflation through higher import prices. It's called the impossible trinity or the trilemma — you can't simultaneously have free capital flows, an independent monetary policy, and a fixed exchange rate. You have to pick two.
Israel has free capital flows and an independent monetary policy, which means it has to accept a floating exchange rate. That's the policy framework the Bank of Israel operates under. They don't target a specific exchange rate level. They let the market determine the rate and use interest rates primarily for domestic price stability. The FX intervention program was an exception, not the norm, and they've now wound it down.
When Governor Yaron says the bank doesn't plan to intervene, he's not saying they'll never do anything. He's saying: we're returning to the orthodox framework where the interest rate serves domestic inflation objectives and the exchange rate floats.
That's actually a sign of confidence in the economy. A central bank that's willing to let its currency float freely is saying: our fundamentals are strong enough that we don't need to manage the price. The market can handle it.
Let's talk about what happens when intervention does happen through the interest rate channel. What does that look like day to day, operationally?
The central bank announces the rate, but the actual implementation happens through open market operations. The Bank of Israel conducts weekly auctions where it either lends to banks or absorbs liquidity from them, depending on whether it wants to push the interbank rate up or down toward the target. If the market rate is drifting above the policy rate, the bank injects liquidity — it lends money to banks at the policy rate, increasing supply and pushing the rate down. If the market rate is drifting below, it absorbs liquidity — it takes deposits from banks at the policy rate, reducing supply and pushing the rate up.
It's supply and demand for bank reserves, managed through weekly auctions.
And commercial banks have accounts at the central bank — these are their reserve accounts. The central bank can also adjust reserve requirements, which is how much banks have to hold relative to their deposits. But the main tool is the open market operation, the weekly auction. It's remarkably mechanical.
The phrase "open market operation" sounds exotic, but you're describing something closer to a utility adjusting water pressure.
That's a good way to think about it. The central bank is managing the liquidity in the banking system the way a water utility manages pressure in the pipes. Too much pressure and things burst — that's inflation. Too little and nothing flows — that's a credit crunch. The policy rate is the target pressure level.
The transmission to the real economy — how long does that actually take?
This is where the "long and variable lags" phrase comes from, which Milton Friedman coined and every central banker now quotes. The conventional estimate is that a change in the policy rate takes about twelve to eighteen months to fully pass through to inflation and economic activity. Some channels are faster — variable-rate mortgages adjust within weeks. Business investment decisions take longer. Wage negotiations take longer still.
Which means a central bank is effectively driving while looking through a foggy windshield. They're making decisions today based on where they think the economy will be in a year and a half.
They're doing it with incomplete data that gets revised multiple times. The initial GDP estimate, the initial inflation reading — those get revised. So you're aiming at a moving target with a delayed feedback loop using a blunt instrument. The fact that central banks get it roughly right most of the time is impressive.
Or they're getting it wrong in ways we don't notice because the counterfactual is invisible. We see what happened, not what would have happened if they'd done something different.
That's the fundamental challenge of evaluating monetary policy — there's no control group. We can't run the economy twice, once with a rate hike and once without. We're always comparing to models and estimates.
Which brings me to something Daniel mentioned that I want to pull on. He said the volatility itself is a problem, separate from the direction. Unpredictability makes long-term decision-making impossible, and businesses can adapt to a known bad variable more easily than an unknown one.
This is a really important point. Exchange rate volatility creates what economists call uncertainty premia. If you're an Israeli exporter pricing a multi-year contract in dollars, you need to hedge against the shekel moving against you. Hedging costs money. Those costs get priced into your bids. You become less competitive not because the exchange rate is too strong, but because you can't predict where it'll be in eighteen months.
If the central bank is actively intervening, it can actually increase that uncertainty, because now you're not just forecasting economic fundamentals — you're trying to guess what the central bank will do.
That's one of the arguments against active FX intervention. It introduces policy uncertainty on top of economic uncertainty. If the Bank of Israel might step in to buy dollars at any moment, or might not, you have to model central bank behavior as part of your currency forecast. That's hard to do well.
There's a case that the cleanest thing a central bank can do for the exchange rate is to have a clear, predictable framework and then mostly stay out of the way.
That's essentially the inflation-targeting framework that most advanced-economy central banks have adopted. You set a clear inflation target — in Israel it's one to three percent — and you adjust the interest rate to keep inflation within that band. The exchange rate floats. You intervene only in cases of extreme disorderly market conditions, not to target a specific level. That predictability is itself a form of stability.
Let me ask about the flip side. When does the predictable framework break down? When does a central bank actually need to step in?
The classic case is when the exchange rate moves so far and so fast that it threatens financial stability. If the shekel were to appreciate by fifteen percent in a month, that's not a market signal — that's a speculative overshoot. Exporters can't adjust that quickly. Their dollar revenues suddenly buy fifteen percent fewer shekels, but their costs are in shekels. Profit margins collapse. If enough exporters are affected, you get layoffs, loan defaults, and a broader economic shock.
That's when the central bank pulls out the direct intervention tools — buying dollars, selling shekels, trying to put a floor under the exchange rate.
Or the opposite. If there's a run on the shekel — capital flight, a security crisis, whatever — the central bank would sell dollars from its reserves to support the currency and prevent a collapse. That's literally what the reserves are for. Israel's two hundred billion in reserves is an insurance policy against that scenario.
It's the financial equivalent of a strategic petroleum reserve. You don't tap it because gas is a little expensive. You tap it when there's a supply crisis.
And the Bank of Israel has been clear about this distinction. Routine shekel appreciation from tech exports and gas revenues — that's fundamentals, let it float. A speculative attack or a disorderly market — that's what the reserves are for.
What about the interest rate as an intervention tool specifically for the exchange rate? Under what conditions would the Bank of Israel cut rates because of the shekel, even if inflation wasn't fully cooperating?
This is the tension point. In theory, if the shekel is excessively strong and it's crushing the export sector, a rate cut weakens the currency by making shekel assets less attractive. But if inflation is above target, cutting rates pours fuel on the inflation fire. The central bank has to weigh: is the damage from the strong currency worse than the damage from higher inflation?
In Israel's case, inflation has been a live concern. Where is it running?
As of early 2025, inflation was running around three point two percent, slightly above the upper bound of the one to three percent target range. The Bank of Israel explicitly cited this as a reason for holding rates steady rather than cutting. They can't cut to weaken the shekel when inflation is already above target — that would compound both problems.
The sequence matters. They hiked to fight inflation. That strengthened the shekel. Now they can't cut to weaken the shekel because inflation isn't fully tamed. They're stuck.
"stuck" is actually the right word. Central banks hate being in this position because it means one of their objectives has to give. Either you accept above-target inflation for a while, or you accept a strong currency that hurts exporters. There's no third option that fixes both simultaneously.
What about the fiscal side? Can the government help?
This is the coordination question, and it's politically charged. If the shekel is strong because of structural factors — tech exports, gas revenues — the exchange rate is sending a signal about the economy's comparative advantage. The policy response shouldn't necessarily be to weaken the currency, but to help the affected sectors adjust. If traditional exporters can't compete at two point nine shekels to the dollar, maybe the answer is investment in productivity, not currency manipulation.
That's a much harder political sell than "the central bank should do something.
Of course it is. Structural adjustment takes years. Rate cuts take effect in months. Politicians and business leaders will always push for the faster fix, even if it creates bigger problems down the road. Central bank independence exists precisely to resist that pressure.
Let's dig into independence, because it's one of those things people nod along with but don't always think through. Why does it matter that the central bank is independent from the government?
Because the government's incentives and the economy's long-term health are not always aligned. A government facing an election in twelve months wants low interest rates, a weak currency to help exporters, and loose credit to boost growth — even if that combination produces inflation that'll hit eighteen months later, after the election. Central bank independence means the rate decision is made by people whose job isn't on the line in the next election.
It's the economic equivalent of not letting the defendant also be the judge.
The evidence is pretty strong that more independent central banks deliver lower and more stable inflation. The Bank of Israel gained its formal independence in 1985 as part of the stabilization program that ended the hyperinflation of the early 1980s. Before that, the government could essentially direct monetary policy for political purposes. The result was inflation that hit four hundred forty five percent in 1984.
Four hundred forty five percent.
Prices nearly quintupled in a year. That's what happens when the central bank is a branch of the treasury and the government prints money to finance deficits. The 1985 stabilization program made the Bank of Israel independent, prohibited direct monetary financing of government deficits, and established the framework that eventually brought inflation down to single digits.
When we talk about central bank independence, we're not talking about an abstract principle. We're talking about a hard-learned lesson from a specific historical catastrophe.
It's a lesson that gets tested whenever times get hard. There's always political pressure to erode independence, to demand that the central bank "coordinate" with the government, which is often a euphemism for "do what we want." Governor Yaron has been fairly explicit about pushing back against this.
How does Israel's structure compare to the Fed's independence?
The Fed is unusual in its degree of independence. It's structured as a system of twelve regional banks plus the Board of Governors in Washington. The regional bank presidents are appointed by their boards, not by the president. The Board of Governors is appointed by the president and confirmed by the Senate for fourteen-year terms — deliberately long, to insulate them from political cycles. The Fed also funds itself through its operations; it doesn't rely on congressional appropriations. That financial independence is a big deal.
The ECB's independence is actually enshrined in the EU treaty. Article 130 explicitly prohibits the ECB and national central banks from taking instructions from EU institutions or national governments. It's the most legally fortified independence of any major central bank. But it operates in a much more politically complex environment, because it has to set one rate for nineteen countries with nineteen different fiscal policies.
Which is the structural weakness. Monetary policy is unified, fiscal policy is national. The two can work at cross purposes.
We saw this during the eurozone debt crisis. The ECB was trying to stabilize the currency union while national governments were running unsustainable deficits. There's no mechanism to force fiscal coordination. That's the fundamental design flaw of the euro — and it's not a flaw they didn't know about. It was a political compromise.
A political compromise that becomes an economic crisis every decade or so.
The sovereign debt crisis, the COVID response, the energy shock — each one tests the institutional architecture.
Let's bring this back to the listener who's trying to understand what all this means for them. Daniel's question was essentially: when I hear about the central bank pondering a few basis points, what am I supposed to take from that?
I think there are three things. First, the rate decision is a signal about where the central bank thinks the economy is going. If they're hiking, they see overheating and inflation risk. If they're cutting, they see weakness and deflation risk. The direction tells you something about the economic outlook.
Second, the rate decision flows through to your personal finances. If you have a variable-rate mortgage, a rate hike means higher monthly payments. If you have savings, higher rates mean better returns on deposits. If you're a renter, higher rates eventually feed into the rental market because landlords' costs adjust. The rate decision is not abstract — it shows up in your bank account.
Third, and this is the one most people miss — the central bank's credibility matters more than any individual decision. A central bank that consistently hits its inflation target, that communicates clearly, that doesn't cave to political pressure — that central bank creates a stable environment where businesses can plan and households can make long-term decisions. The specific twenty-five basis point move matters less than whether people believe the central bank knows what it's doing and will do what it says.
Credibility as the ultimate policy tool.
It really is. If the central bank says "we target two percent inflation" and everyone believes them, inflation expectations stay anchored. Wage negotiations assume two percent. Price-setting assumes two percent. That anchoring makes the central bank's job easier because it doesn't have to fight against expectations. If credibility is lost, expectations become unanchored, and the bank has to hike much more aggressively to re-establish control. The Volcker Fed in the early 1980s is the classic example — he had to push the federal funds rate to twenty percent to break inflation expectations that had become completely unmoored.
That's what happens when credibility is lost. The cost of regaining it is enormous.
The pondering over a few basis points — that's not fiddling while Rome burns. That's the maintenance of a delicate institutional asset that took decades to build and can be destroyed in months.
Every careful deliberation, every basis point decision, every measured communication — it's all in service of preserving that credibility. Because the alternative is the kind of economic chaos that Israel experienced in the 1980s, and that nobody wants to go back to.
On the exchange rate specifically — when the central bank says it's not intervening, that's also a credibility play. They're saying: we trust the market, we trust our fundamentals, and we're not going to try to micromanage the price of the currency.
Which is a bet. It's a bet that the floating exchange rate will find a level that reflects economic reality, and that the benefits of letting it float outweigh the costs of the occasional overshoot. It's not a risk-free bet. Exporters will complain. Politicians will complain. But the alternative — trying to manage the exchange rate through a combination of FX intervention and interest rate adjustments — has its own costs, and historically, those costs tend to accumulate quietly until they become a crisis.
The quiet accumulation of costs until they become a crisis — that's basically the theme of half our episodes.
It's the theme of economic history, honestly. The things that break are rarely the things everyone was watching.
To wrap this around to the concrete question. When you hear that the Bank of Israel is holding the rate at four point five percent and not intervening in the FX market, here's what that means in practice. The central bank has decided that inflation is still a concern, that the economy doesn't need stimulus, and that the strong shekel, while painful for exporters, reflects genuine economic strength that intervention would only distort. They're choosing stability, credibility, and orthodoxy over short-term relief for the export sector.
They're doing it with a tool — the policy rate — that they adjust in twenty-five basis point increments through weekly liquidity auctions, knowing that the full effects won't be visible for a year or more, and that their real power comes not from any individual decision but from the cumulative credibility of getting it mostly right over time.
Not bad for a bunch of economists in a room with a whiteboard.
The whiteboard probably has a lot of Greek letters on it.
Of course it does.
And now: Hilbert's daily fun fact.
Hilbert: In sepak takraw — a sport best described as volleyball played with the feet — the official rules specify that a server must have one foot inside the service circle and the other foot outside it, a stance so biomechanically specific that it has been known to produce what the sport's governing body formally classifies as a "service anomaly," wherein a player becomes temporarily unable to distinguish which foot is which.
That's not a rule, that's a neurological experiment.
I have followup questions I'm not sure I want answered.
This has been My Weird Prompts. Thanks to our producer, Hilbert Flumingtop. You can find every episode at myweirdprompts.com, and if you've got a question that keeps you up at night — about economics or anything else — send it our way. We'll do our best to make it slightly less mysterious, or at least more interesting. I'm Herman Poppleberry.
I'm Corn. Until next time.
