Low Inflation Opens the Door to an Unusual Run of Rate Cuts

Israel may be headed toward three consecutive interest rate cuts, an unusual move by the Bank of Israel, after this week’s consumer price index came in weaker than expected. The May CPI fell 0.3%, versus forecasts for a drop of about 0.1% to 0.2%. Over the past 12 months, inflation was 1.9%, still within the Bank of Israel’s 1% to 3% target range. The decline was led by a sharp drop in airfare, alongside lower prices for fresh vegetables and transportation, while fresh fruit and clothing rose. Home prices also surprised on the upside, falling 1.3% year on year.

Economists said airfares, which have become highly volatile since the Central Bureau of Statistics changed its methodology in 2023, distorted the headline reading. Matan Shtrit, chief economist at Phoenix Group, said airfare alone subtracted about 0.4% from the index, after adding 0.5% in the previous report. He said inflation excluding that component is still rising, but remains under control near the middle of the target. Yonatan Katz, chief economist at Leader Capital Markets, argued that airfare cannot simply be ignored because it is seasonal, but said the bigger concern is accelerating rents, which may keep climbing for months.

Bank of Israel Governor Amir Yaron said two weeks ago at the Horowitz Economics Conference that if inflation expectations keep falling, that would justify a looser monetary policy at a faster pace. Market participants now see a 100% chance of a 0.25% cut at the next decision, and two full cuts over the next three rate meetings, according to Shtrit. Katz expects cuts in July and August, and possibly another later in the second half of the year or at the start of 2027, taking the rate to 3% within a year. He said a half-point cut looks too aggressive, though he would not rule it out if the dollar returns to 2.8 shekels, the Iran deal advances, and the security situation in Lebanon remains calm.

Shtrit said the current backdrop, a softer-than-expected CPI, the ceasefire, a strong shekel, lower oil prices and a low risk premium, should lead the bank to cut rates at the upcoming decision. He also warned that markets may be pricing in too much easing too soon, especially because wage pressures are rising and Israel’s money supply is growing quickly. The Bank of Israel will publish its next interest rate decision and updated research division forecast in July. Its previous March forecast, issued during the Iran operation, assumed inflation would reach 2.3% in early 2027 and the policy rate would be 3.5% to 3.75%, but market expectations have since shifted sharply lower.