The Bank of Israel announced a 25 basis point cut in its benchmark interest rate on Jan. 1, bringing it down to 4.5%. This was the first rate cut in nearly four years, and was supported by all five members of the monetary policy committee (MPC). The decision was based on the moderation of inflation, which fell to 3.3% year-on-year in November, and the expectation of a return to the 1-3% target range in the first quarter of 2024. The MPC also cited the slowing of global activity, which reduces the pressure from imported prices.
The rate cut was somewhat expected by the market, as the central bank had held rates steady for four consecutive meetings, after raising them 10 times from 0.1% in April 2022 to 4.75% in September 2023. The MPC had previously signalled that it was nearing the end of its tightening cycle, as inflation had peaked at 4.9% in August 2023 and started to decline.
War with Hamas poses inflationary risks
However, the MPC also expressed its concern about the possibility of inflation rising again, due to several factors related to the ongoing war with Hamas. The war, which started on Oct. 7, 2023, when Hamas gunmen attacked several Israeli cities, has caused significant damage to infrastructure, disrupted economic activity, and increased uncertainty. The MPC noted that the war could have both supply and demand effects on inflation, depending on its duration and intensity.
One of the main risks is the depreciation of the shekel, which has lost about 10% of its value against the US dollar since the outbreak of the war. A weaker currency makes imports more expensive, and could also fuel inflation expectations. The MPC said that it would monitor the exchange rate closely, and intervene if necessary to prevent excessive volatility.
Another risk is the fiscal expansion that the government has undertaken to finance the war and compensate the affected citizens. The cabinet approved an amended 2024 budget on Monday, adding 55 billion shekels ($15 billion) of extra spending, mainly for defence and civilian purposes. This is expected to increase the budget deficit to around 7% of GDP, well above the original target of 3.5%.
The MPC warned that fiscal expansion could have an inflationary impact, if it is not offset by spending cuts elsewhere or by higher revenues. The MPC also said that fiscal policy could affect the pace of monetary policy, as looser fiscal policy would require tighter monetary policy to maintain price stability. Deputy Governor Andrew Abir told Reuters after the rate cut that “there’s always a balance between monetary policy and fiscal policy. If fiscal policy is more expansive then monetary policy probably needs to take that into account.”
Economic recovery uncertain amid war
The MPC also said that it was too early to assess the impact of the war on economic activity, as the data available so far was limited and partial. The MPC said that there had been a gradual recovery in activity after an initial sharp decline in the wake of Oct. 7, but that the situation remained fragile and volatile.
The MPC said that it would continue to monitor the developments in the economy and the financial markets, and adjust its policy accordingly. The MPC said that its policy was focused on stabilising the markets and reducing uncertainty, alongside price stability and supporting economic activity.
The MPC also reiterated its commitment to use all the tools at its disposal, including unconventional measures, if needed. The Bank of Israel has already implemented several measures to ease the liquidity and credit conditions in the market, such as expanding its bond purchase program, providing cheap loans to banks, and offering swap lines to foreign central banks.
The next interest rate decision is scheduled for Feb. 1, 2024.
