Bank of Israel Cuts Interest Rate for Third Time Amid Economic Concerns

The Bank of Israel announced on Tuesday its decision to lower the benchmark interest rate by a quarter of a percentage point for the third consecutive time, bringing it down from 3.5% to 3.25%. The move surprised some market observers, as many economists had considered leaving the rate unchanged as a distinct possibility. The Monetary Committee stated that the decision aims to stimulate the economy, which is still underperforming its trend line in various sectors.

According to the committee's statement, second-quarter growth data partially reflects an economic recovery from the impact of "Operation "Lion's Roar" in the first quarter. However, excluding the activity of Israeli companies abroad, growth in the first half of the year was more moderate. Second-quarter 2026 GDP was 3.8% higher than the last quarter of 2025 on an annualized basis. Current economic indicators show credit card spending in current prices as volatile and slightly below the long-term trend. While business trend surveys indicate a continued improvement following the operational impact, net balances in most sectors remain below pre-March 2026 levels. High-tech capital raising in the third quarter stood at approximately $3 billion, lower than in the first two quarters. Foreign trade data for July showed a moderation in goods exports after a sharp rise in May and June, with a significant increase in services exports in June.

The committee anticipates that several factors will influence inflation in opposing directions. Geopolitical developments and their impact on economic activity, energy prices, risk premiums, and exchange rates will play a significant role, as will demand alongside supply constraints and fiscal developments. Regarding fiscal considerations, uncertainty surrounds the defense budget for 2026 and subsequent years, the scope and timing of government adjustments to fund it, and its effect on projected deficits.

This decision was made despite a hawkish speech by Fed Chair Kevin Warsh at Jackson Hole, which increased market expectations for a US interest rate hike on September 16th. Renewed tensions between the US and Iran have also recently pushed up the dollar and oil prices, weakening the shekel against the dollar. While the shekel has strengthened over the year, helping to moderate inflation, it has weakened by only about 0.5% against the dollar since the previous rate decision. The primary argument for those who expected a rate cut was inflation, which fell to a five-year low of 1.5% in July, well below the central bank's target range of 2%. However, the governor recently noted "very strong" second-quarter growth figures and predicted inflation would accelerate to 2% in the coming months.

The Monetary Committee faced a complex dilemma, as noted by Leader Capital Markets. While inflation is moderating, the shekel is relatively strong, and the labor market shows signs of easing, the Bank of Israel has historically adopted a cautious approach, especially during economic recovery periods. The committee acknowledged that after two consecutive rate cuts, it could afford to slow the pace of reductions. Significant geopolitical events since the last rate decision include the collapse of the US-Iran understanding, rising oil prices, and the US declaration of economic war on Iran, with no clear path for the reopening of the Strait of Hormuz. Global market risk has increased, with US Treasury yields near multi-decade highs. Locally, recent weeks have seen renewed tension in Gaza regarding Hamas's disarmament and increasing friction with Hezbollah in Lebanon, despite a framework agreement.

Alex Zabrzinski, chief economist at Meitav, was among analysts who predicted a rate decrease, arguing that geopolitical uncertainty warrants higher interest rates primarily when accompanied by financial instability, such as currency depreciation or rising inflation expectations. In the absence of these factors, and when shocks harm economic activity, research supports a more accommodative policy as long as expectations remain anchored.