Central bank cuts growth forecast amid fears of intense war, escalation of fighting

Bank of Israel head Amir Yaron urges the government to make responsible budget adjustments, even if they are not popular, to help fund war costs and restore investor confidence

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, January 2, 2023. (Yonatan Sindel/Flash90)
Bank of Israel Governor Amir Yaron speaks during a press conference at the Bank of Israel in Jerusalem, January 2, 2023. (Yonatan Sindel/Flash90)

The Bank of Israel on Monday slashed the growth outlook for the economy citing a “high level” of geopolitical uncertainty amid expectations of a prolonged and more intense war with the Hamas terror group and increased risk of an escalation with Iran-backed Hezbollah on the northern border.

Speaking at a press conference in Jerusalem, Governor Amir Yaron said that the central bank “assumes that the war will continue at a higher intensity until the end of 2024, and will wind down in the beginning of 2025 — later than in the previous forecast,” in April.

Therefore, the central bank now expects the economy to grow by 1.5 percent in 2024 and, and 4.2% in 2025. That is down from a previous growth forecast in April of 2% in 2024 and 5% in 2025.

Alongside the revised growth forecasts, the central bank decided to hold the benchmark interest rate at 4.5% for a fourth consecutive meeting, which is in line with forecasts by the majority of economists. 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 economy is facing very high uncertainty,” said Yaron. “The economy’s growth rate moderated in the second quarter, and supply constraints are weighing on the convergence of economic activity to the prewar trend.”

At the same time, Yaron emphasized that Israel’s country risk premium is at a “high level and has continued to increase in the recent period.”

Firefighters work to extinguish a fire following an attack from Lebanese Hezbollah terror group, in the Golan Heights, July 4, 2024. (AP Photo/Gil Eliyahu)

“A high risk premium for a long period of time has an adverse impact on real economic activity,” he remarked.

Israel is in its 10th month of a war with Hamas, which began October 7 when thousands of terrorists streamed into Israel by land, sea, and air, murdered some 1,200 people, mostly civilians, while taking 251 hostages of all ages into Gaza.

Meanwhile, fears of an all-out war between Israel and Hezbollah have intensified in recent weeks as ongoing efforts to secure a ceasefire and hostage release in Gaza appear to be gathering momentum.

Tensions with Hezbollah have soared after a series of high-profile strikes Israel has carried out on the Iran-backed terror group. Hezbollah has responded with large numbers of missile and drone strikes, which have caused fires to burn across Israel’s north.

Yaron noted that since the last interest rate decision, the shekel weakened by about 1.3% against the dollar, “with high volatility in view of the various developments in the geopolitical environment.”

An escalation of the ongoing war to the northern front with Hezbollah in Lebanon is of concern to the central bank as it would incur additional defense and civilian expenditure leading to a higher fiscal deficit and a weaker shekel.

Police at the site where a rocket fired from Lebanon hit and caused damage in the northern town of Katzrin, June 13, 2024. (Michael Giladi/Flash90)

War costs have already driven up defense and civilian spending, leading to a fiscal shortfall of 7.6% of gross domestic product in June and breaching the deficit target ceiling of 6.6% that the government set for 2024. The central bank still expects 2024 to end with a budget deficit of 6.6%, it said on Monday.

Looking ahead to the 2025 budget plans, Yaron turned to the government, urging policymakers to adhere to fiscal responsibility to prevent the deficit from spiraling out of control during the current challenging and uncertain war period, .

“If decisions will be taken that involve additional permanent increases in the defense budget, further adjustments will have to be made accordingly,” Yaron demanded. “It is the government’s responsibility to take the necessary steps, even if some of them may not be popular, to ensure economic stability and to promote sustainable growth.”

The warning comments come as the Finance Ministry is drafting the 2025 budget outline, which the central bank hopes will help create some investor certainty about spending cuts and tax increases on the revenue side, to fund war costs. Since the start of the fighting, Finance Minister Bezalel Smotrich has been harshly criticized for failing to adjust fiscal priorities to address wartime needs and support the economy’s recovery.

Despite making moderate spending cuts in the 2024 revised budget, Israel’s right-wing coalition has left in place billions of shekels in discretionary funds made available to political allies under deals reached in coalition talks.

“If the government only partially implements the fiscal adjustments required, or defers the approval of the budget into 2025, and/or approves further increases in military expenditures and permanent expenditures, it is liable to lead to an additional increase in Israel’s risk premium,” Yaron cautioned. “Such a situation is liable to lead to an adverse impact on the economy’s growth path and to an additional increase in interest payments on the government debt that will ultimately be passed on to the public.”

Assuming that fiscal adjustments of a permanent nature of a total of NIS 30 billion will be made by the government, the central bank expects the deficit in 2025 to decline to about 4% of GDP.

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