(Bloomberg) — The Bank of Israel is considering keeping interest rates on hold for the rest of the year after hinting at up to three interest rate cuts to support the war-hit economy.
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The record increase in budget spending is spilling over into inflation, which is nearing the upper end of the government’s 1% to 3% target range after two months of acceleration, likely delaying the start of interest rate cuts by the US Federal Reserve and potentially even altering the Bank of Israel’s timetable for monetary easing.
After slashing interest rates at the start of the year, Israeli policymakers have adopted a more neutral stance as the war with Hamas drags on for more than seven months.Economists surveyed by Bloomberg unanimously expect the Monetary Committee to keep its policy rate unchanged at 4.5% for a second consecutive session when it meets on Monday for the first time since November.
Citigroup no longer expects Israel to cut rates again this year, and Bank Hapoalim said it is “by no means certain,” as traders backtracked on seeing more rate cuts imminent.
“There are growing concerns that the differential between Israeli and U.S. interest rates could lead to a further decline in the already volatile shekel, potentially increasing inflationary pressures,” said Ronen Menachem, chief market economist at Mizrahi Tefahot Bank.
A widening interest rate differential between Israel and the United States threatens to scare off capital inflows and weaken the local currency.The shekel has recently recouped some of the losses it suffered in March and April, but its three-month volatility of more than 10 percent makes it third behind the Chilean peso and Russian ruble among 31 major currencies tracked by Bloomberg.
“Central banks will always choose to risk leaving interest rates too high for a long period of time, even though this could affect growth, rather than making hasty cuts that could lead to higher inflation and interest rates potentially even higher than before,” Menachem said.
As of 2:49 p.m. Tel Aviv time ahead of Monday’s interest rate decision, the shekel was down 0.5% against the dollar, on track for its biggest drop in more than a week. It has fallen about 1.7% this year.
Israel’s war costs have already reached $16 billion, and as of April the budget deficit for the past 12 months had ballooned to 7% of gross domestic product. Bank of Israel Governor Amir Yaron has repeatedly called on the government to adopt responsible fiscal policies in the face of soaring defense spending.
“Increasing government spending and a widening fiscal deficit are also contributing to inflationary pressures, and in these circumstances the central bank is likely to adopt a more restrictive monetary policy,” said Asher Blass, former chief economist at the Bank of Israel.
After a recovery in the first quarter, the Israeli economy is coming under increasing price pressure amid a darkening outlook. The biggest uncertainty is the duration and intensity of the conflict, with the army currently expanding its operation against Hamas in Rafah and continuing fighting with Lebanese militia Hezbollah in the north.
The fighting has disrupted everything from construction to retail, and as a result, economic growth is expected to slow in the coming quarters, even as GDP remains 2.8% below pre-war levels.
The Bank of Israel predicts the economy will grow 2 percent this year, while S&P Global Ratings and Moody’s Investors Service see much weaker growth of around 0.5 to 0.6 percent.
But the central bank has less room to stimulate as inflation has resurfaced and is rising at its fastest pace this year, hitting 2.8% in April. Expectations for price increases a year from now rose for the fifth consecutive month in May to 3%, according to a central bank survey.
Accelerating increases in food prices, especially dairy products, are expected to keep inflation on track this month, and the cost of air travel will also soar.
Analysts at Bank Hapoalim’s financial division expect 12-month price growth to be 3.2 percent and “assess risks are biased towards higher inflation,” they said in a report. “Interest rate cuts will likely be long overdue,” the analysts said.
Economists at Goldman Sachs Group Inc. reversed their cut forecast on Monday and now expect no change. “Two recent surprise upside gains in inflation, elevated inflation expectations and continued high geopolitical uncertainty are likely to prompt the Bank of Israel to postpone its easing of policy.”
Still, “looking further out, we maintain a relatively dovish view on Israeli interest rates,” they said, expecting a rate-cutting cycle to begin in the third quarter. “The stronger shekel is likely to provide a driver for containing inflation in the coming months.”
–With assistance from Joel Rinneby.
(Updated to add Shekel performance in 8th paragraph.)
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