Israel's Central Bank Holds Interest Rates Amid Political and Security Uncertainty

Bank of Israel decided on Wednesday to maintain the benchmark interest rate at 3.25%, despite slowing inflation that has stabilized within the target range. This decision was made amidst political and security uncertainty, less than a week before the Knesset elections scheduled for October 27. The Monetary Committee announced its decision, which aligned with analysts' expectations of no rate cut before the elections. The decision also kept the prime lending rate, used for most mortgages and consumer loans, at 4.75%.

Bank of Israel stated its policy focuses on price stability, supporting economic activity, and market stability. Future interest rate adjustments will depend on inflation and economic activity developments, geopolitical uncertainty, and overall financial trends. The decision follows a 0.5% decrease in the consumer price index in September, exceeding expectations, with annual inflation at 1.6%, within the bank's target range. This marks a pause after a previous quarter-point cut to 3.25% in its last decision, which reduced average monthly mortgage payments by approximately 65 shekels.

Previously, the bank lowered rates to 3.75% in May, citing falling inflation and a strengthening shekel, after holding them at 4% in March due to the war and fears of rising fuel prices. In February, rates were also held steady despite lower inflation amid tensions between Washington and Tehran. At that time, Finance Minister Bezalel Smotrich criticized the decision as "wrong and not supported by Israeli macroeconomic data."

Financial institutions have differing forecasts for future rate cuts, with some anticipating a reduction soon and others warning rates might remain high until late next year. Some experts predict a cut to 3% in the coming months, arguing that structural factors underpin low inflation, making high rates compared to other countries unsustainable long-term. Others foresee moderate cuts in the first quarter of 2027, contingent on a government forming and passing a growth-encouraging budget. They suggest the absence of such a budget could delay cuts unless economic activity significantly slows, amid concerns about increased government spending and debt-to-GDP ratios. Some even expect rates to remain unchanged until at least the end of 2027, with Bank Hapoalim estimating equal probabilities of a rate cut or hike next year.

These varied estimates reflect differing economic interpretations. Some institutions believe the bank will await election results, government formation, and budget approval before easing monetary policy. Foreign trade data shows rapid economic expansion, reducing the immediate need for rate cuts. Inflation is expected to rise to 2.3% next year, partly due to the re-imposition of a temporarily reduced fuel tax. Bank Hapoalim noted that political uncertainty and shekel fluctuations limit the central bank's maneuverability, while also pointing to anticipated rate hikes by major developed economies' central banks. Conversely, projections favoring cuts are based on slowing inflation, weak consumer demand, and a stagnant housing market, with Bank Hapoalim reporting a 1.8% drop in apartment prices over the past year.

Concurrently with the interest rate decision, Bank of Israel released updated economic forecasts, projecting 5.6% GDP growth in 2026 and 7.5% in 2027. These figures assume the continuation of military operations at a low level without significant escalation. However, the bank clarified that these high growth rates are largely driven by external production from Israeli companies, not solely domestic economic activity. Researchers highlighted that this is primarily linked to Nvidia's overseas sales, which are included in economic output calculations. Therefore, the bank presented an alternative indicator excluding foreign production, which it considers a better reflection of domestic economic activity. This indicator forecasts 3.4% growth in 2026 and 5.1% in 2027, highlighting a significant difference between gross and domestic growth figures.

These projections follow recent data showing a slight increase in capital market inflation expectations for next year, from 1.6% in September to 1.7% in October. Average expectations from commercial banks and economic consultancies rose to 2.1% from 2% the previous month. This indicates the bank is balancing current disinflation with potential economic and political risks affecting prices and activity, with future rate decisions tied to these evolving factors.