Bank of Israel Set to Cut Interest Rate Amid Inflation Control and Political Risks

The Bank of Israel's Monetary Committee is expected to reduce the interest rate by 0.25 percentage points to 3.5% today, a move widely anticipated by all 14 economists surveyed by Reuters and fully priced into the markets. The Overnight Index Swap (OIS) market assigns a 92% probability to this quarter-point cut and only an 8% chance of a larger 0.5 percentage point reduction to 3.25%. The key question now is not whether the rate will be cut, but how much further the Bank will ease rates by the end of the year.

Inflation in Israel has returned to the target range, averaging 1.9% from January to May, with ten consecutive months below the 3% ceiling set by the government. Inflation expectations remain well anchored between 1.7% and 2.3%. Despite ongoing pressures from non-tradable goods, especially housing, most tradable goods prices are stabilizing, indicating the Bank has largely contained inflation. The shekel has strengthened sharply this year, and external inflationary pressures have eased, supporting the case for rate cuts. However, the Bank is expected to maintain a relatively hawkish tone due to tight labor markets, high wage growth, strong private consumption recovery, robust high-tech exports, and financial system stability.

The main risks now are geopolitical and political rather than economic. Although markets have largely returned to normal, Israel remains in a volatile security environment where regional flare-ups could rapidly impact exchange rates, risk premiums, and economic activity. The International Monetary Fund (IMF) also advises cautious monetary policy due to geopolitical risks, energy prices, supply constraints, and regional uncertainty.

Additionally, political risks are rising as Israel approaches elections. The government is expanding fiscal spending with new budget initiatives, grants, and coalition deals, despite a high debt-to-GDP ratio of about 70% and no clear fiscal consolidation plan. Defense spending is expected to remain elevated, and the economy still faces war-related costs. This fiscal expansion pressures the Bank of Israel to act cautiously to avoid reigniting inflation through demand pressures. Governor Amir Yaron has repeatedly emphasized fiscal responsibility and macroeconomic stability.

Investors will closely watch whether the upcoming rate cut signals the start of a sustained easing cycle or a one-time adjustment. The paradox is that the Bank is cutting rates because it has succeeded in controlling inflation but cannot afford to celebrate due to ongoing political and fiscal uncertainties. The Bank’s caution remains paramount, shifting focus from external shocks to domestic political and fiscal challenges that could pose the greatest macroeconomic threat in the coming year.