Israel Interest Rate to Hold Steady Amid Election Uncertainty, Analysts Say

Analysts at Psagot Investment House predict that the Bank of Israel will maintain its current interest rate at its upcoming meeting on Wednesday, citing the upcoming Knesset elections and the resulting uncertainty surrounding the next government's economic policies. In their weekly review published Monday, Psagot noted that while inflation levels currently allow the Bank of Israel to wait, future economic decisions post-election could influence the pace of future rate cuts.

The proximity of the elections and the Bank of Israel's interest rate decision this week is expected to encourage the central bank to avoid further action until the political landscape becomes clearer. Short-term inflation is considered low enough that even upward surprises, such as the cancellation of the fuel excise tax discount or further conflict with Iran, are unlikely to push it above 3%. However, Psagot highlighted several medium-to-long-term uncertainties facing the Bank of Israel.

These include political stability, as election ties could lead to further elections and prolonged uncertainty. The subsequent challenge will be the state budget, particularly the potential for a permanent increase in defense spending. The financing of these expenditures is another key issue, with a proposed ten-year defense budget increase of NIS 300 billion requiring significant fiscal adjustments if the deficit is to be kept at its current level.

Psagot recalled that similar adjustments in 2024 involved a 1% VAT increase, a freeze on income tax brackets, public sector wage adjustments, and cuts in civilian ministries. The investment house deems a repeat of such measures unlikely, suggesting the government might opt for a higher deficit target or classify some defense spending as extra-budgetary. Such a move could lead to a stable or rising debt-to-GDP ratio, potentially reducing the scope for future interest rate cuts.

Despite these factors, Israel's economic activity continues to grow at a pace consistent with historical trends. Psagot estimates that if a government is formed that can enact a budget including deregulation and measures to boost the economy, the Bank of Israel might resume moderate rate cuts in the first quarter of 2027. Alternatively, another rate cut would only occur if data indicates a significant economic slowdown.

In the United States, expectations for an imminent interest rate hike have also moderated. Following inflation data and rising bond yields that had raised concerns about a late October hike, a speech by former Federal Reserve governor Kevin Warsh at the IMF lowered the probability of such a move to about 15.5%. While Warsh did not provide explicit guidance, his remarks suggested that developments since the September rate decision align with the Federal Reserve's expectations, reinforcing the possibility of a December hike but also the chance of a wait-and-see approach. Meanwhile, the yield on 10-year US Treasury bonds fell to 5.1%, after reaching 5.32% during the week. Psagot explained that market dynamics, including stock market movements and AI investments, are influencing bond yields, with continued AI investment potentially supporting higher rate expectations, while a slowdown could moderate them.