Bank of Israel cuts growth forecast again due to war impact, leaves benchmark steady

The Bank of Israel on Monday lowered its growth outlook for this year and next year citing a “high level” of uncertainty regarding the duration and scope of the war with the Hamas terror group as well as the lack of appropriate government decisions that are needed to fund the economic fallout arising from it.

Assuming that the war will be concentrated mainly on the southern front, the central bank said it now expects the economy to grow by two percent in each of 2023 and 2024. That is down from its previous forecast in October of growth of 2.3% in 2023 and of 2.8% in 2024, when the central bank cut its previous projections of 3% growth for this year and next year.

“The revised forecast was built under the assumption that the war’s direct impact on the economy will continue into 2024 although with declining intensity — as opposed to the assumption in the October forecast that the direct impact will be concentrated in the fourth quarter of 2023 alone,” the central bank said in a statement.

Along the revised growth forecasts, the central bank decided to hold the benchmark interest rate at 4.75%, in line with forecasts by the majority of economists. The Bank of Israel’s monetary policy decision to keep borrowing costs unchanged for a fourth time since July comes as Israel is 52 days into a war with Hamas, which began October 7 when some 3,000 terrorists streamed into Israel by land, sea, and air, murdered some 1,200 people, mostly civilians, while taking hostages of all ages into Gaza.

To bring down rising inflation, the Bank of Israel has, over the past 19 months, steadily hiked interest rates from a record low of 0.1% in April 2022 to 4.75% in July this year, and has since paused with the cycle of pushing up borrowing costs. The high interest burden already began to take a toll on households and mortgage holders even before the outbreak of the war.

The economic fallout from the war and expected downturn in private consumption and demand, prompted the Finance Ministry and global credit rating agencies to cut their growth prospects in recent weeks, as the fighting is estimated to cost the economy as much as NIS 200 billion ($54 billion).

Israelis inspect damaged cars after they were hit by a rocket fired from the Gaza Strip in Ashkelon, southern Israel, October 13, 2023. (AP Photo/Tsafrir Abayov)

According to central bank research department assessments, gross government spending on the war is expected to amount to about NIS 160 billion, and the loss of revenue from lower tax income is expected to to total NIS 35 billion.

As such, the central bank forecast estimates that the budgetary costs of the war (expenditures plus loss of income) are expected to amount to 10% of GDP, Yaron said.

As a result, the government budget deficit, will need to widen to 3.7% of GDP in 2023 and 5% of GDP in 2024, according to estimates by the central bank’s research department. The debt to GDP ratio, one of the most significant fiscal indicators, is expected, according to the forecast, to increase to 63% in 2023 and 66% at the end of 2024.

Although Yaron reiterated that Israel’s economy is “robust and stable,” and has known in the past how to recover in previous conflicts, and return rapidly to prosperity, he emphasized that one of the main pillars of uncertainty to the economy’s recovery is the commitment of the government to redirect expenditure in the 2024 state budget and prioritize security and civilian needs.

The cabinet was set on Monday to approve a NIS 30 billion change to prioritize wartime needs in the remaining portion of the 2023 state budget over objections that the plan will also send hundreds of millions of shekels to ultra-Orthodox and West Bank settler priorities. The central bank has been criticizing that the Treasury’s proposed cuts to the 2023 budget are not enough and that the government needed to free up additional non-war-related spending, including discretionary coalition funds, to tackle the costs of the ongoing fighting.

War cabinet minister Benny Gantz warned Sunday that failure to divert all coalition discretionary funds to war needs would cause his National Unity party to vote against a proposed war budget and could lead it to “consider its next steps,” hinting he could bolt the government.

Israelis inspect a damaged residential building after it was hit by a rocket fired from the Gaza Strip, in Ashkelon, Israel, October 9, 2023. (Erik Marmor/AP)

As the economic adviser of the government, the central bank governor urged lawmakers to maintain a responsible fiscal framework that would see a gradual return to the “desired debt to GDP ratio of approximately 60% at the beginning of the war.”

“The markets look at the economy… also from the medium and long term… therefore, it is important that the government cut new expenditures of a prolonged nature,” Yaron urged.

Yaron explained that current short-term war costs, including the replenishing of the Israeli army’s stocks, civilian expenditures, and massive rehabilitation of the communities that were destroyed will gradually wind down with the recovery of the economy and the end of the fighting.

“At the same time, it is likely that government expenditures will increase due to a permanent increase in security expenditures, and an increase in interest payments, due to the public debt level increasing and becoming more expensive,” said Yaron. “These expenses are expected to be much smaller than the current costs of the fighting; however, they are significant, as they will continue for a long time.”

“Therefore, it is important to make decisions soon regarding the budget adjustments not only for 2023, but also indicate commitments for cuts in 2024 that will support a continued reduction of the debt to GDP ratio,” he remarked.

The central bank head added that as a new 2024 budget is only expected to be built in the first months of next year, it is important that already now the government demonstrates its commitment to fiscal responsibility by material decisions to reduce expenditures that have become less essential.

A building in Tel Aviv damaged by rocket fire from the Gaza Strip on October 7, 2023. (JACK GUEZ / AFP)

“The reduction should be via adjustments on items that have a permanent impact, and that make a lower contribution to economic growth,” Yaron recommended. “Thus, these will serve as sources for dealing with the expected increase in the defense budget in the years following the war as well, with the debt to GDP ratio liable to otherwise continue increasing without such adjustments.”

“Such a decline is important in order to maintain the credibility of fiscal policy in the view of the markets, and to prepare for additional crises that the State of Israel is liable to face in the coming years,” he emphasized.

Israel’s annual inflation rate over the past 12 months has eased to 3.7% in October and has been declining from 4.1% in August, but it is still above the government target range of between 1% to 3%.

The central bank sees inflation moderating in the coming months and return in the first half of 2024 to the target range.

“Despite inflation expectations being anchored, the effects of the war on the inflation processes are still not clear,” cautioned Yaron. “These will depend on the relative severity of the supply limitations and the decline in demand.”

“To the extent that the financial markets’ recent stability will become entrenched and the inflation environment will continue to moderate toward the target range, the more that monetary policy will be able to support economic activity,” said Yaron hinting at the scenario of the possibility for an interest rate cut in the coming months.