Bank of Israel leaves lending rate at 4.5%, as inflation and war uncertainty ramp up

Central bank has kept rate steady since cutting it in January; says it expects the deficit to rise due to war costs, pushing the state to make budgetary cuts and raise taxes

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 7, 2019. (Noam Revkin Fenton/Flash90)
Bank of Israel Governor Amir Yaron speaks during a press conference at the Bank of Israel in Jerusalem, on January 7, 2019. (Noam Revkin Fenton/Flash90)

The Bank of Israel on Monday left interest rates unchanged, citing a pickup in inflationary pressure, and continued geopolitical uncertainty, as the seven-month-old war with the Hamas terror group continues to bite into the economy.

Central bank governor Prof. Amir Yaron cautioned that, as defense spending needs are expected to increase due to the duration and extent of the war, lawmakers will have to make responsible fiscal adjustments in the 2025 budget, and indicated that other measures, such as raising taxes, may also be needed to bolster the government’s coffers.

“We are seeing an increase in the inflation environment and geopolitical uncertainty, which are making rate cuts more challenging,” Yaron said in an interview with Channel 12. “We understand that defense spending may need to rise, but we can’t use a blank check.”

The Bank of Israel decided to hold interest rates for a third consecutive time at 4.5 percent. In January, the central bank lowered the base lending rate for the first time in almost four years by 25 basis points, from 4.75%, to support households and businesses as the economy was getting battered due to the Hamas war, and as the inflation environment was easing.

The bank’s monetary policy committee warned about “several risks of a potential acceleration in inflation: geopolitical developments and their effects on economic activity, a depreciation of the shekel, continued supply constraints on activity in the construction and air travel industries, fiscal developments, and global oil prices.”

“In view of the war, the monetary committee’s policy is focusing on stabilizing the markets and reducing uncertainty, alongside price stability and supporting economic activity,” the Bank of Israel said.

Ahead of Monday’s decision, economists were in consensus that interest rates would remain steady and forecast that borrowing costs for mortgage and loan holders would stay high for longer in the coming few months amid heightened inflationary pressure, persistent regional tensions, and higher fiscal spending as defense costs rise.

A damaged home following a rocket attack in the northern city of Kiryat Shmona, May 5, 2024. (David Cohen/ Flash90)

“This path of expectations is fundamentally different from what we saw only a month and a half ago when quite a few of the expectations in the market, including ours, were actually for an interest rate cut,” said Mizrahi Tefahot Bank chief strategist Yonnie Fanning.

Fanning noted that the uncertain geopolitical situation was among the top factors in the Bank of Israel’s interest rate decision, alongside reports of price increases in energy and some food costs, which raised concerns for inflationary stability.

Consumer prices in Israel over the past two months quickened at a faster pace than forecast, led by an increase in housing prices and higher travel and transportation costs, according to data by the Central Bureau of Statistics. In April, the year-over-year inflation rate accelerated to 2.8%, up from 2.7% in March, and 2.5% in February. The government’s annual target range of inflation is between 1% and 3%.

“The inflation dynamic has increased,” the central bank said in Monday’s announcement. “In the housing market, home prices continue to increase and the constraints and difficulties in the industry’s activity in view of the war remain significant… affected mainly by the shortage of workers and the uncertainty about them.”

The Bank of Israel has in recent weeks been warning about the factors putting upward pressure on inflation, including higher government spending due to the costs of the Hamas war in Gaza, and increased geopolitical uncertainty.

The war with Hamas broke out in response to the terror group’s October 7 massacre in southern Israel, in which close to 1,200 people were slain and 252 were kidnapped to Gaza, where about half are believed to remain.

IDF reservists guard a Hamas tunnel discovered in northern Gaza’s Salatin, close to Jabaliya, December 7, 2023. (Emanuel Fabian/Times of Israel)

In the first three months of this year, the economy bounced back, growing by an annualized 14.1% following a 21.7% contraction in the previous quarter, as the Gaza war took a heavy toll on consumer spending, trade and investment.

“Beyond the security effects, the war has economic consequences, both on real activity and on the financial markets,” the central bank said. “Data indicate improvement in activity in the first quarter… However, the activity level has not returned to its prewar level and is impacted mainly by supply constraints.”

“Alongside this, continued geopolitical uncertainty is reflected in the economy’s high risk premium,” it added.

War costs have boosted defense and civilian spending by almost NIS 60 billion ($16 billion), leading to a fiscal shortfall of 7% of gross domestic product in April and breaching the deficit target ceiling of 6.6% that the government set for 2024.

“The cumulative annual deficit is expected to continue to climb in the coming months, and to converge back to an environment similar to the current one toward the end of 2024, provided that there are no notable deviations in security expenditures,” the Bank of Israel said.

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