Bank of Israel keeps rates steady due to Gaza war uncertainty

The Bank of Israel kept interest rates steady on Monday after cutting by a quarter-point in January, citing uncertainty over expected duration of the war in Gaza that will keep the pace of rate reductions this year gradual.

In keeping its benchmark rate ILINR=ECI at 4.5%, the central bank said the war was having "significant economic consequences" on real activity and on the financial markets.

"It has been four difficult months for Israel," Bank of Israel Governor Amir Yaron told a press conference. "Beyond security issues, the war brings with it marked economic ramifications as well. It impacts on economic activity overall and on the financial markets, and the uncertainty remains high."

Israel's war against Palestinian terrorist group Hamas began on Oct. 7 after Hamas rampaged through Israeli towns.

Yaron said that while there was great uncertainty with regard to the expected severity and duration of the war, Israel's economy "rests on solid and resilient foundations" and typically recovers after military conflicts and "returns rapidly to prosperity."

The risk of inflation

One factor in holding rates this decision, he said, was higher budget spending to finance the war and which "presents a risk to the continued moderation of inflation" that has eased to a rate of 2.6% in January, within an official 1-3% target.

In January, Yaron said the pace to rate cuts would be gradual and on Monday he said that estimate was "reasonable."

He said that worldwide, the inflation environment has moderated in many countries but remains above central banks’ targets, with central bankers worried over inflation in services, which has pushed back monetary easing.

Analysts polled by Reuters were split ahead of the decision, with seven expecting no move and seven projecting another 25 basis point reduction. They believe the key rate will drop to 3.5% to 4% during 2024.

Prior to January's cut, it had raised rates 10 straight times in an aggressive tightening cycle from a all-time low of 0.1% in April 2022, before pausing last July.

The economy contracted by an annual 19.4% in the fourth quarter, reflecting the toll of the war with Hamas, to end 2023 with growth of 2%.

"Indicators of economic activity and the state of employment point to a gradual recovery following the sharp decline that took place with the outbreak of the war, but there is variance between industries," the central bank said.

Yaron said he was concerned over the construction sector, which has been hit with a lack of workers, although the overall jobs market was recovering.

In the wake of a credit ratings downgrade by Moody's this month, which stemmed from the war's uncertainty, Yaron said cut had apparently been already priced in by markets.

"To strengthen the trust of the markets and ratings companies in Israel’s economy, it is important that the government and Knesset (parliament) act to deal with the economic issues raised in the report," he said. "These will

require structural changes in government ministries and prioritizing growth drivers."