Bank of Israel makes first interest rate cut since 2020

Shekel down as Bank of Israel cuts interest rates for the first time in four years

On Monday, the Bank of Israel (BoI) reduced short-term borrowing rates for the first time in almost four years, making it the first developed country to ease monetary policy, while stressing the need for fiscal discipline as Israel grapples with increased spending during the war with Hamas.

The decision to lower interest rates, the first since April 2020, was influenced by the stabilization of financial markets since the outbreak of the war on October 7, a decrease in inflation, and a slowdown in economic growth, according to the central bank. The Israeli shekel responded to the announcement by sliding against the U.S. dollar — at the time of writing on Tuesday, the USD to ILS exchange rate was last 3.6355, with the shekel down 0.91% against the greenback on the day.

"The war is having significant economic consequences, both on real economic activity and on the financial markets," the central bank said. "There is a great amount of uncertainty with regard to the expected severity and duration of the war, which is in turn affecting the extent of the impact on activity."

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Bank of Israel: Governor Yaron points to fiscal responsibility amid “budgetary burden” of war

Bank of Israel Governor Amir Yaron stressed that future rate cuts would depend, in part, on fiscal policy and the Israeli government’s responsibility to adhere to a prudent fiscal approach, especially given the expected defence and civilian costs of the war, estimated at 210 billion shekels ($58 billion). Yaron stressed the importance of addressing this “budgetary burden” through spending reductions in non-critical areas related to the war and by raising state revenue — which typically means higher taxes.

"If the markets perceive that Israel is moving toward a prolonged path of rising debt it is likely to lead to increased yields, depreciation and inflation, such that a higher central bank interest rate will be required," said Yaron, who was just approved for a second and final five-year term as the governor of the Bank of Israel.

He pointed out the government's inaction so far on making needed budget adjustments — such as cutting back redundant ministries, without giving details of which ministries he meant.

Israel’s Finance Ministry is currently estimating a 2024 budget deficit of around 6% of GDP.

"Not acting now ... is likely to cost the economy much more in the future," Yaron added. "What is needed now is a responsible budget that requires adjustments and decisions that are not easy regarding priorities."

Israel interest rate: Analysts split prior to announcement, shekel slips after cut implemented

In response to the rate cut, Finance Minister Bezalel Smotrich commended the move but appeared to downplay Yaron's call for budget discipline:

"The responsible fiscal policy that we have been leading for the past year has contributed to the decrease in inflation, and now the lowering of the interest rate serves the need to help the growth of businesses and the economy at the same time as the war”.

Analysts were split before the central bank's decision to lower the benchmark rate from 4.75% to 4.50%, with seven expecting no change and seven anticipating a 25-basis point reduction, according to a recent Reuters poll. The bank had previously presided over an aggressive tightening cycle, raising rates in ten consecutive moves, before pausing in July and then again in August, October, and November.

The inflation rate decreased from 3.7% in October to 3.3% in November but remained above the annual target range of 1%-3%.

The bank maintained Israeli economic growth forecasts for 2023 and 2024 at 2%, with a growth projection of 5% outlined for 2025. The bank also forecast a gradual decline in the interest rate to 3.75% by the end of the year from the current 4%.

The interest rate decision saw the dollar to shekel rate tip in favour of the greenback to trade at 3.6352 on January 2. The shekel was the world’s top-performing currency in November last year, after support from the Israeli central bank propelled it to recover to pre-war levels. The conflict initially led the currency to an 11-year low before its fortunes reversed on the back of foreign exchange sales and the provision of $15 billion through swap lines by the BoI.

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