The war with Iran, surprisingly, boosted optimism on the local capital market in almost every respect. The stock market reached new heights, prices of government bonds shot up, and the shekel strengthened against the US dollar to a level not seen in two and half years. In the real economy, however, the picture is less rosy. Besides the military costs, the war has meant huge government expenditure on compensation to businesses, and to those whose homes have been damaged. Private consumption was also depressed by the state of emergency and the closure of businesses. Has the time arrived for the Bank of Israel to cut its interest rate?
The rate is currently 4.5%, after a single cut, in January 2024, following the outbreak of the Swords of Iron war in the Gaza Strip. Since them, contrary to the trend in most countries (other than the US), the interest rate has remained the same. Why? First of all, because the Bank of Israel is legally required to keep the annual rate of inflation in the 1-3% range. The inflation rate in the twelve months to the end of May was 3.1%. Apart from that, the Bank of Israel is concerned about risks that could accelerate inflation, chiefly the ongoing war in the Gaza Strip, which creates uncertainty for economic activity, raises fears of supply-side constraints, and causes volatility in shekel exchange rates. In addition, the US president’s tariff measures are expected to cause extensive price rises.
War costs
The war with Iran imposes huge costs. Following the outbreak of war in the Gaza Strip, it should be recalled, the government raised the rate of VAT from 17% to 18%, which contributed to higher prices, and it is not inconceivable that a further similar measure will be considered because of the costs of the war in Iran. There are also additional inflationary risks arising from the situation, such as a rise in rents (which account for a quarter of the Consumer Price Index) because of greater demand from people evacuated from their homes, and the fear that Israelis will set off a rise in prices with a spending spree to compensate for two weeks in which the economy was largely shut down.
Less uncertainty
“The inflation story isn’t over, since there’s pressure on rents as a result of the war, and the airlines have not restored all the flights, but I think that the end of the event reduced the uncertainty,” says Danny Yardeni, head of Bank Leumi’s nostro management division. “The Bank of Israel has stated more than once that one of the factors that keeps the interest rate at its current level is uncertainty, but it now looks as though, in the geopolitical equation, the uncertainty has receded.
“The shekel is strengthening, and inflation expectations as priced in by the capital market are touching 2%, right in the middle of the Bank of Israel’s target range. I believe that these are signs that will enable the Bank of Israel to examine the possibility of not leaving the interest rate at its current level.”
Yardeni adds: “We are in a situation in which the state needs a great deal of money for rehabilitation. It’s clear that fiscal intervention is required here. But monetary intervention should also be on the agenda. The market is already pricing in an interest rate cut.”
The Bank of Israel Research Department sees an average interest rate of 4% until the first quarter of 2026, but the markets are more optimistic, and estimate that the rate will fall faster. Yardeni himself expects one rate cut within the next few months. He says that without an end to the war with Iran, “the expectation of an interest rate reduction was a first cut only towards the end of the year, or even early next year.”
Israel not alone
Israel, however, is not entirely alone in the high interest rate band. The US Federal Reserve rate is also 4.5%, despite public pressure from President Trump to reduce it. “In the US too, the view that inflation is under some kind of control (an annual rate of 2.4% in May, H. S.), and that there’s room to start thinking about cutting the interest rate, is becoming widespread. I’m not sure that we in Israel are in a very different position. Five-year inflation expectations in the US are at 2.3%, and they’re at around 2% in Israel. If calls for an interest rate reduction are growing in the US, then it certainly shouldn’t be different in Israel.”
Nevertheless, Yardeni stresses that “the labor market in Israel is tight.” As demand for workers grows, so do upward pressures on wages, which translates into higher prices all round. “Therefore,” Yardeni says, “the interest rate should not be cut sharply in my opinion, but there is room to examine a gradual reduction.”
An interest rate cut will make life easier for people with mortgages and other loans, but it will also make investment in bonds, money market funds, and bank deposits less attractive.
Yardeni recommends that investors should not make big changes to their portfolios in anticipation of an interest rate cut. “Everything could blow up again in seconds,” he says, and recommends CPI-linked government bonds with a medium duration, of two to four years.
Published by Globes, Israel business news – en.globes.co.il – on June 29, 2025.
© Copyright of Globes Publisher Itonut (1983) Ltd., 2025.
