Bank of Israel now eyes longer war with less room to cut rates

(Bloomberg) — Israel’s central bank unveiled a revised outlook that assumes the country is at risk of a longer and more intense war, as it held interest rates steady for the fourth straight time Monday.

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Speaking to reporters after leaving the benchmark rate at 4.5%, Governor Amir Yaron said officials now expect the conflict to ease only in early 2025. The latest staff projections showed the benchmark rate set at 4.25% in the second quarter of 2025, a more aggressive trajectory than previously suggested.

Other estimates released Monday indicate that the central bank’s research department now anticipates faster inflation and slower economic growth this year than it had forecast in April.

“Due to the revised assumption regarding the duration of the fighting, our assessment is that the risk premium, which has increased due to the war, will decline more gradually than we assumed in April, so a higher interest rate will be needed to stabilize inflation,” the Bank of Israel’s research staff said in a report.

The shekel erased its losses after the decision and was trading 0.2% stronger against the dollar at 6:12 p.m. in Tel Aviv.

As Israel’s war against Hamas has dragged on for ten months, the risk of open conflict with Iran-backed Hezbollah in Lebanon is increasing. As negotiations on a ceasefire agreement in Gaza have resumed, Prime Minister Benjamin Netanyahu’s government is preparing for the possibility of open war with Hezbollah militants in Lebanon.

The central bank’s timetable for war roughly matches the views of senior officials like the country’s national security adviser, Tzachi Hanegbi, who said in late May that Israel would likely not be able to defeat Hamas before the end of the year.

An escalation of hostilities on the northern border with Lebanon threatens to lead to further depreciation of the shekel, supply disruptions and a heavier fiscal burden, which would intensify inflationary pressures.

Public spending has already skyrocketed because of the war, putting Israel on track for one of its largest budget deficits this century.

Finance Ministry data released on Monday showed the 12-month budget deficit stood at 7.6% of gross domestic product in June, higher than the government’s estimate of 6.6% for the whole of calendar year 2024.

Yaron said Monday that the government will have to make adjustments in next year’s budget totaling NIS 30 billion ($8.2 billion) to reach a target deficit of 4 percent of GDP.

“It is the government’s responsibility to take the necessary steps, even if some of them are not necessarily popular, to ensure economic stability and promote sustainable growth,” Yaron said. Refraining from such measures would lead to a further increase in Israel’s risk premium, as markets would perceive Israel’s debt burden as being on an uncontrollable trajectory, he added.

Uncertainty is already spreading through markets, with the yield on 10-year shekel government bonds hitting a 13-year high of 5.2% this month. The shekel has lost more than 3% against the dollar since the start of March, making it one of the worst-performing currencies among a basket of 31 major currencies tracked by Bloomberg.

Annual price growth is currently 2.8%, which is within the official range but is on track to exceed the upper limit of 3%. Bank Hapoalim forecasts inflation of 3.3% over the next 12 months and Leader Capital Markets expects it to reach 3.4%, depending on the value of the shekel against the dollar.

“We expect the Bank of Israel to be cautious and not deliver further rate cuts this year,” Barclays Plc economists including Zalina Alborova said ahead of Monday’s decision. “Even in an improving geopolitical scenario, inflationary pressure is likely to prevent the bank from delivering a cut.”

–With assistance from Joel Rinneby.

(Updated with central bank forecast, comments starting in first paragraph.)

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