War budget casts shadow over Israel’s first rate cut since Covid
ISRAEL’S central bank warned the government’s fiscal response to the war against Hamas risks pushing the country into greater debt and could be an obstacle to further monetary easing, after it cut interest rates for the first time since the height of the global pandemic in 2020.
The monetary committee on Monday (Jan 1) ended a pause in place since July and lowered its key rate to 4.5 per cent from 4.75 per cent, as predicted by most economists. Markets are betting rates will fall below 3.4 per cent by the end of 2024.
An updated outlook from the central bank’s research department showed the government is on track to run a bigger budget deficit than was estimated in November, with the fiscal costs of the war also upwardly revised to around 210 billion shekels (S$77 billion).
“A risky fiscal policy can affect rate decisions moving forward,” governor Amir Yaron said at a news conference, calling for adjustments that cut back expenditure and boost income.
“If the markets perceive that Israel is moving towards a prolonged path of rising debt, it’s likely to lead to increased yields, depreciation and inflation, such that a higher central bank interest rate will be required,” he said.
The decision signals priorities are starting to shift in favour of supporting the economy, after an effort by policymakers to steady markets following the attack by Hamas on Oct 7. The focus has changed with a slowdown in inflation and as local assets recouped their losses while the shekel staged the world’s biggest rally versus the US dollar in the past two months, gaining over 12 per cent.
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The shekel pared gains after the rate announcement and traded little changed against the US dollar.
In a statement accompanying the decision on Monday, policymakers largely repeated their guidance from November, saying the focus is on “stabilising the markets and reducing uncertainty, alongside price stability and supporting economic activity”.
The central bank gave no clear signal about the timing of what it plans to do next. Its research department projects the interest rate at 3.75 to 4 per cent in the fourth quarter of 2024.
Yaron said the forecasts suggest the Bank of Israel may cut rates as many as four times this year, calling it “a more moderate path of decline than that assessed by the market”.
“The interest rate path will be determined in accordance with developments in the war and the uncertainty derived from it,” the central bank said. “Insofar as the recent stability in the financial markets becomes entrenched and the inflation environment continues to moderate towards the target range, monetary policy will be able to focus more on supporting economic activity.”
The case had been building for Israel to deliver some monetary stimulus as inflation converged on the 1 to 3 per cent goal for the first time since 2021 and the economy at risk of a contraction. The central bank said on Monday it expects inflation will enter the target range in the first quarter of the year.
“Until the decision, the Bank of Israel was focused on financial stability,” said Nira Shamir, chief economist at Israel Discount Bank. “Now they are taking a proactive step – they are trying to help households.”
War, budget
Risks abound, however, as the central bank weighs the implications of fiscal plans linked to the Hamas war, which could saddle the country with a bigger debt load.
Differences with the government may prove critical to what happens next as officials reshape the budget during wartime.
A Finance Ministry report published in December cited a 75 billion-shekel war bill that will need to be funded with borrowing or budget cuts, combined with higher taxation. The government has so far indicated it is not willing to take steps that the central bank will likely consider sufficient to keep debt in check.
The risk that the war against Hamas could expand into a wider conflict is another reason for future caution. Disruption persists across the economy with the deployment of hundreds of thousands of troops, and whole communities evacuated from their homes along Israel’s southern and northern borders.
Yaron said on Monday that besides a “transitory increase” in the budgetary costs from the war, Israel also faces a more permanent burden from bigger defence outlays, higher interest expenses and other long-term spending commitments linked to the conflict’s fallout.
The outlook means that to fund these increases, the government would need to make cumulative fiscal adjustments “of a permanent nature” that would total about 30 billion shekels annually by the end of 2025, he said.
The central bank’s research department assumes such changes will ensure that public debt as a share of economic output will start declining after 2025. A failure to modify the budget poses the risk of the debt-to-GDP ratio rising in the years ahead.
“A marked portion of the above adjustments should already be made in the 2024 budget,” Yaron said. “Not acting now to adjust the budget via cuts in expenditures, removing redundant ministries and increasing revenues in view of the needs of the war is likely to cost the economy much more in the future.” BLOOMBERG
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