Inflation Expectations Hit Four-Year Low, But Rate Cuts Remain Uncertain

Business sector inflation expectations for the coming year have fallen to 2.02%, the lowest level since January 2022, down from 2.4% at the end of 2025. Concurrently, the budget deficit narrowed to 3.2% of GDP in the twelve months ending in August, a slight decrease from 3.3% the previous month. While these figures would typically signal room for further interest rate cuts, the situation remains ambiguous. A recent analysis by Leader Capital Markets, led by chief economist Yonatan Katz, titled "Continued Interest Rate Cuts Are in Doubt," suggests that the current interest rate of 3.25% may see at most one reduction in the next three months to a year, with rates potentially remaining unchanged.

Economic activity, however, shows signs of gradual recovery. The business sector trends survey indicates a moderate improvement, with the current activity component rising in August to 20.15 points from 18.09 in July, nearing pre-operation levels. The high-tech sector is a notable bright spot, with expectations for next month's service exports showing a sharp increase, despite a projected stagnation in employment within the industry. A softening labor shortage, particularly in services and construction, is contributing to the moderate inflation environment. This easing is partly attributed to an increase in foreign workers and the return of reservists to the workforce, impacting wages and subsequently prices.

On the fiscal front, data exceeds expectations. Government spending from the start of the year rose by 3.6% year-on-year, with defense spending surging 10.9% above the budgeted 9.3% increase. Other ministries' spending remained largely unchanged, with the budget allocating a 6.4% increase. Leader Capital Markets suggests that legal constraints, including High Court petitions, may be preventing the disbursement of certain coalition budgets. Tax revenues increased by 13.9%, or 9.6% in real terms, excluding tax rate changes. The Ministry of Finance anticipated an additional NIS 10 billion from Nvidia tax revenues, with the review estimating the actual figure to be higher. Even with anticipated acceleration in civilian spending and an additional NIS 25 billion approved for defense, the deficit is projected to be around 4.0% to 4.2% of GDP, below the 4.6% target.

Global agricultural commodity prices have risen sharply, with wheat up 42%, corn 22%, and sugar 14% over the past year. Factors contributing to this include rising oil prices impacting fertilizer costs due to the Strait of Hormuz blockade, Black Sea shipping disruptions from the Ukraine war, and concerns over crop yields due to warming ocean temperatures. Despite these global trends, the impact on food prices in Israel has been moderate, with consumer price index increases of 0.9% year-to-date and 1.5% year-on-year. The strengthening shekel has largely offset the rise in import prices for consumer goods and food. Leader Capital Markets has revised its inflation forecast for the coming year to 2.2%, primarily due to food prices, compared to an estimated 3.5% rise in Europe.

External factors also pose a concern, with a global rise in yields potentially threatening stock markets. Expansionary fiscal policies are becoming common worldwide, fueled by election cycles in Europe and campaign promises in the US. Many central banks are tightening monetary policy, with the European Central Bank recently raising rates and the US and Japan expected to follow suit. The US Treasury's bond purchase program fell short of expectations, and significant investments in AI data centers are increasing demand for capital. The regional outlook remains uncertain regarding Iran, and Israel's long-term bond yields have seen a slight decrease over the past year, unlike most other countries. Political and geopolitical uncertainty, rising commodity prices, and a moderate shekel depreciation may impact long-term capital gains, while market inflation pricing favors inflation-linked assets. Conversely, the formation of a stable government could benefit the markets. The upcoming August inflation index is expected to show a 0.8% to 0.9% increase, largely due to seasonal factors. The US Federal Reserve's interest rate decision is anticipated on Wednesday, with market expectations for a rate hike exceeding 80% following the release of US inflation data.