Bank of Israel holds rates for now, warns about judicial risk to economy

Central bank governor Amir Yaron calls on lawmakers to ensure legislative changes will be carried out in broad agreement, and will uphold strength and independence of institutions

Sharon Wrobel is a tech reporter for The Times of Israel.

Bank of Israel Governor Amir Yaron speaks during a press conference at the Bank of Israel in Jerusalem on January 2, 2022. (Yonatan Sindel/Flash90)
Bank of Israel Governor Amir Yaron speaks during a press conference at the Bank of Israel in Jerusalem on January 2, 2022. (Yonatan Sindel/Flash90)

The Bank of Israel on Monday decided to leave its benchmark interest rate unchanged at 4.75 percent for the first time in more than a year, in light of the first signs that inflation is moderating, but warned that it will not hesitate to raise borrowing costs in coming months should the uncertainty around the contentious judicial overhaul lead to an increase in the country’s risk premium and continued shekel weakness.

The hike pause comes after the central bank steadily raised interest rates from a record low of 0.1% in April 2022 for 10 consecutive times to 4.75% at the end of May in a bid to rein in inflation. The aggressive interest rate increases have been rapidly fueling the costs of mortgage and loan holders, who are struggling to pay off monthly payments.

Meanwhile, political uncertainty around the Israeli government’s proposed judicial overhaul has seen the shekel weakening by almost 10% since the start of the year. Depreciation in the local currency raises the price of imported goods such as food and gas and travel abroad and leads to higher inflation. Speaking after the interest rate decision, Bank of Israel governor Amir Yaron estimated that weakness in the local currency has led to “excess” inflation of at least 1% to 1.5%, while indicating that if the trend continued the central bank would need to raise borrowing costs to rein in price growth.

Commenting on the impact of the proposed judicial overhaul on the economy in recent months, Yaron cautioned that the advancement of the legal changes has led to an increase in the level of uncertainty in the Israeli economy, as reflected, in “excess depreciation” of the shekel and the underperformance of the Israeli stock market versus global markets.

“Continued uncertainty is liable to have notable economic costs,” said Yaron. “Therefore, it is important to bring back the stability and certainty to the Israeli economy, and to verify that legislative changes will be carried out with broad agreement, and will maintain the strength and independence of the institutions.”

Yaron made the comments as Knesset was set to vote Monday on a controversial bill to curtail judicial review of the “reasonableness” of elected officials’ decisions, as part of the government’s broader plan to overhaul Israel’s judiciary. Should the parliamentary coalition clear the bill through its first reading, the protest movement that has been going onto the streets in the past six months has promised nationwide disruptive demonstrations on Tuesday, including blocking roads and flooding Ben Gurion Airport and its internal access roads with protesters.

Israelis protest against the government’s planned judicial overhaul, outside the President’s Residence in Jerusalem, on July 8, 2023 (Photo by Noam Revkin Fenton/Flash90)

The Israeli market has largely been anticipating the Bank of Israel’s pause in rate hikes after the US Federal Reserve held off on further raising borrowing costs in June and consumer prices in Israel in May rose at more than half the rate than was forecast. The only factor cited by economists for the possibility of higher borrowing costs was the depreciation of the shekel.

Since the last monetary policy decision at the end of May, the shekel has weakened by 1.8% against the US dollar and by 2.3% against the euro.

“The market was pricing in a probability of less than 20% for an interest rate increase today, but is pricing in a probability of about 80% for a rate hike in the coming months,” Bank Discount chief economist Nira Shamir wrote in a research note on Monday ahead of the rate decision. “We see the Bank of Israel preferring to take a “time out” (as other governors have done) and continuing to examine the implications of the interest rate increases over the past year, including the CPI indices for June–July that will be published until the next decision (September 4, 2023) and the Central Bureau of Statistics estimates of economic growth in the second quarter.”

Despite the monetary tightening steps by the Bank of Israel over the past year, inflation is still far above the government’s target range of 1% to 3% in recent months. In May, the consumer price index (CPI), a measure of inflation that tracks the average cost of household goods, increased by 0.2%, below analysts’ expectations of between 0.5% and 0.6%. The May results show annual inflation over the past 12 months at 4.6%, after hovering around 5% for more than six months.

Yaron stressed on Monday that the current interest rate level in the economy was sufficiently restrictive to support bringing inflation back down to the price target range over the coming year, unless further depreciation in the shekel fueled by local uncertainty creates a need on the part of the Bank of Israel to continue raising borrowing costs.

The governor also cited a slowdown in the pace of credit card purchases, the cooling of the real estate market and decline in mortgage volume, and a contraction in the the job vacancy rate as factors pointing to signs of a moderation trend in economic activity, deriving from the interest rate policy, which is working to reduce inflation.

Illustrative: 100 shekel banknotes, seen December 31, 2017. (Nati Shohat/Flash90)

“In the past half year, we have experienced a marked depreciation of the shekel, derived mainly from domestic factors and less from the global environment,” Yaron said. “To the extent that the shekel’s weakness will continue, it is liable to weigh on the return of inflation to its target, and therefore necessitate a more restrictive monetary policy.”

The Bank of Israel’s research department on Monday also revised this year’s growth forecast for the economy upward assuming that the disagreements around the proposed legislative changes are resolved in a way that does not have an adverse impact. The central bank now forecasts Israel’s economy will grow 3% in both 2023 and in 2024 slowing from 6.5% last year. That compares with its growth forecast of 2.5% for 2023 previously.

Based on the forecast, annual inflation is expected to decline to 3%, on average, in the second quarter of 2024 and to 2.4% at the end of 2024.

“The main risk to the forecast is the realization of a scenario in which legislative and institutional changes are accompanied by an increase in the country’s risk premium and continued depreciation of the shekel, an adverse impact on exports, and declines in domestic investments and demand for private consumption,” Yaron said.

Yaron, who is due to end his term as governor at the end of 2023, said he will announce his decision whether to ask to stay on for another five-year term around the Jewish holidays in September-October.

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