The Bank of Israel is expected to keep its short-term interest rates at 4.5% for the fourth consecutive meeting, according to a Reuters poll of 15 economists. The decision to maintain the benchmark rate comes amid a backdrop of the war in Gaza, persistent inflation, and an increasing risk premium. Despite forecasts of a 3.2% inflation rate, the actual rate held steady at 2.8% in May, remaining within the target range of 1-3%. However, the rate has inched up from 2.5% since February.
Morgan Stanley economist Alina Slyusarchuk highlighted the challenges facing the Bank of Israel, citing “persisting inflation pressures, geopolitical risks, currency weakness, and fiscal expansion” as factors limiting the central bank’s ability to ease monetary policy. The decision to cut the key rate by 25 basis points in January was preceded by 10 consecutive rate hikes, signaling an aggressive tightening cycle from the all-time low of 0.1% in April 2022. The ongoing war in Gaza, which began in October, has contributed to high geopolitical uncertainty and risk premiums.
Despite a sharp contraction in the final quarter of 2024, the Israeli economy rebounded by an annualized 14.4% in the first quarter of 2025, alleviating immediate pressure for a rate cut. Bank of Israel Governor Amir Yaron expressed reservations about further rate cuts as long as inflation persists and the conflict with Hamas continues to fuel uncertainty and government spending. The budget deficit has climbed to 7.2% of GDP, surpassing the 2024 target of 6.6%, largely due to increased defense expenditures.
Escalating Risk Premium
The escalation of tensions with Iran-backed Hezbollah on the Lebanese border has added to Israel’s risk premium, contributing to volatility in the shekel exchange rate. The threat of a second war looms as Hezbollah launches rockets in support of Hamas, prompting retaliatory strikes from Israel. These ongoing security concerns have kept the risk premium elevated and could influence future monetary policy decisions.
In addition to the interest rates announcement, the Bank of Israel will release updated macroeconomic estimates and Governor Amir Yaron will host a news conference. Analysts anticipate the central bank to maintain a cautious stance, signaling a potential reduction in interest rates in the coming year while emphasizing the impact of geopolitical risks on the economy. Despite the challenging economic environment, the Bank of Israel remains vigilant in navigating the complexities of monetary policy amid ongoing uncertainties.
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