Bank of Israel expects longer war and less scope for interest rate cuts

(Bloomberg) — Israel’s central bank issued a new outlook that predicted the country faces a longer and more intense war and left interest rates unchanged for the fourth consecutive month.

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After leaving the benchmark interest rate at 4.5 percent, Governor Amir Yaron told reporters on Monday that officials now expect the conflict against Hamas in the Gaza Strip to subside only in early 2025. The latest forecasts by central bank staff showed that the benchmark interest rate is likely to be 4.25 percent in the second quarter of 2025, a more aggressive stance than previously indicated.

The central bank’s research department expects higher inflation and slower economic growth this year compared to April forecasts.

“Due to the changed assumptions regarding the duration of hostilities, we expect the risk premium increased by the war to decline more slowly than expected,” the researchers said in a report. “To stabilize inflation, a higher interest rate will be necessary.”

The shekel was trading 0.1 percent weaker at 8:50 p.m. in Tel Aviv, at 3.68 against the dollar.

As talks on a ceasefire in Gaza resumed, Prime Minister Benjamin Netanyahu’s government warned of a possible open war with Iran-backed Hezbollah in Lebanon, a group considered far more powerful than Hamas in terms of the number of its fighters and the size of its rocket arsenal.

“The economic consequences would clearly be greater compared to the current war in Gaza,” said Andrew Abir, deputy governor of the central bank, in an interview after the interest rate decision. “It would be an event that would be much more serious in terms of its impact on the Israeli economy. I think at the moment the markets are giving a fairly low probability of such an event.”

The central bank’s timetable for the Gaza war roughly corresponds to the views of the country’s national security adviser, Tzachi Hanegbi. At the end of May, he said that Israel would probably not be able to defeat Hamas before the end of the year.

An escalation of hostilities on the northern border with Hezbollah could lead to a further devaluation of the shekel, which has fallen by almost 3.5 percent since the beginning of March. It would also lead to supply shortages and a greater fiscal burden for Israel, increasing inflationary pressures.

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Government spending has already skyrocketed because of the war, and Israel is on track for one of the largest budget deficits this century.

Finance Ministry data released on Monday showed the budget deficit for the past 12 months to June rose to 7.6 percent of gross domestic product, above the government’s estimate of 6.6 percent for the full calendar year 2024.

Yaron said the government would need to make adjustments totaling NIS 30 billion ($8.2 billion) in next year’s budget to reduce the deficit.

“It is the government’s responsibility to take the necessary steps to ensure economic stability, even if some of them may be unpopular,” Yaron said. Failure to do so will lead to a further increase in Israel’s risk premium because markets will have the impression that Israel’s debt burden is on an uncontrollable path, he said.

According to Goldman Sachs Group Inc., Israel’s credit rating deteriorated more than that of any other emerging market in the first half of this year, primarily due to the country’s weakening financial position.

Uncertainty is already spilling over into the markets: the yield on the government’s 10-year shekel bonds hit a 13-year high of 5.2 percent this month.

Annual price growth is currently at 2.8 percent, within the official target range but likely to exceed the upper limit of 3 percent.

Bank Hapoalim, one of Israel’s largest banks, expects inflation to reach 3.3 percent over the next twelve months, and Leader Capital Markets expects it to rise to as much as 3.4 percent.

“We expect to miss the target in the next few months and then hopefully get back towards the target by the end of the year or early next year,” said Deputy Governor Abir.

He said the central bank wanted inflation not to remain above target for more than “a few months” and “to be confident that it will return significantly within the range.”

According to Barclays Plc, the bank is unlikely to begin easing its monetary policy before 2025.

“We expect the Bank of Israel to play it safe and not make any further rate cuts this year,” the bank’s economists, including Zalina Alborova, said ahead of the rate decision. “Even in a scenario of geopolitical improvement, inflationary pressures are likely to prevent the bank from making a rate cut.”

– With support from Joel Rinneby.

(Updated with comments from the Deputy Governor.)

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