Bank of Israel Sees Longer War and Less Room for Rate Cuts

Israel’s central bank unveiled a new outlook that assumes the country faces a longer and more intense war, as it held interest rates for a fourth consecutive time.

Governor Amir Yaron, speaking to reporters on Monday after leaving the benchmark at 4.5%, said officials now expect the conflict against Hamas in Gaza to wind down only in early 2025. The latest staff projections from the bank showed the key rate will probably be at 4.25% in the second quarter of 2025, a more hawkish path than implied earlier. 

The central bank’s research department now anticipates faster inflation and slower economic growth this year compared with forecasts from April.

“Due to the revised assumption regarding the duration of the fighting, our assessment is that the risk premium, which rose due to the war, will decline more gradually than we assumed,” the research staff said in a report. “A higher interest rate will be necessary in order to stabilize inflation.”

The shekel traded 0.1% weaker, at 3.68 against the dollar, as of 8:50 p.m. in Tel Aviv.

While talks on a cease-fire in Gaza have resumed, Prime Minister Benjamin Netanyahu’s government has warned of the possibility of an all-out war with Iran-backed Hezbollah in Lebanon. The group is considered far more powerful than Hamas in terms of numbers of fighters and the size of its arsenal of missiles and rockets.

“Economic implications would clearly be of larger scale compared to the present war in Gaza,” Andrew Abir, the central bank’s deputy governor, said in an interview after the rate decision. “It’ll be an event that would be much more severe in terms of its impact on the Israeli economy. I think at the moment markets are giving a fairly low probability to such an event.”

The central bank’s timeline for the war in Gaza is roughly in line with the views of the country’s national security adviser, Tzachi Hanegbi. In late May, he said Israel probably won’t be able to defeat Hamas before the end of the year.

An escalation of hostilities across the northern border with Hezbollah could cause further depreciation of the shekel, which is down almost 3.5% since the start of March. It would also lead to supply disruptions and a greater fiscal burden for Israel, all of which would intensify inflationary pressures.

Government spending has already soared because of the war, putting Israel on track for one of its widest budget deficits this century. 

Finance Ministry data published Monday showed the 12-month trailing fiscal shortfall ballooned to to 7.6% of gross domestic product as of June, higher than the government’s estimate of 6.6% for the full calendar year of 2024.

Yaron said the government will need to make adjustments in next year’s budget, totaling 30 billion shekels , to bring the deficit down.

“It is the government’s responsibility to take the necessary steps, even if some of them may not be popular, to ensure economic stability,” said Yaron. If not, it will lead to an additional increase in Israel’s risk premium because markets will perceive Israel’s debt burden as being on an uncontrollable path, he said.

Goldman Sachs Group Inc. said Israel’s sovereign risk score worsened more than that of any other emerging market in the first half of this year, primarily because of its weakening finances.

The uncertainty is already spilling over into markets, with the yield on the government’s 10-year shekel bonds reaching a 13-year high of 5.2% this month.

Annual price growth is now at 2.8% — within the official target range but on track to exceed its 3% upper limit.

Bank Hapoalim, one of Israel’s largest lenders, sees inflation at 3.3% over the next 12 months and Leader Capital Markets believes it will accelerate to as much as 3.4%.

“We expect it to go outside the target over the next few months or so before, hopefully, coming back into the target toward the end of the year or in the beginning of next year,” Abir, the deputy governor, said. 

The central bank, he said, wants inflation to be above target for no more than “a couple of months” and “to be confident that it will come back well within the range.”

It’s unlikely the bank will start easing monetary policy until 2025, according to Barclays Plc.

“We expect the Bank of Israel to err on the side of caution and not offer any more rate cuts this year,” the lender’s economists, including Zalina Alborova, said before the rate decision. “Even in a scenario of geopolitical improvement, inflation pressure is likely to prevent the bank from delivering a cut.”

With assistance from Joel Rinneby.

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