The Monetary Committee has decided to keep the interest rate unchanged for the eighth consecutive time at 4.50%. This decision reflects a decrease in the country risk premium, attributed to the relative improvement in the security situation and progress in passing the 2025 budget. Consequently, there are more optimistic assessments about economic activity for the coming year, and the growth forecast for 2025 has been raised to 4%. However, the Committee acknowledges that high demand, supported by a tight labour market, combined with supply constraints and the government’s tax increases, continues to pose an upward risk to inflation.

Given the geopolitical and fiscal uncertainties, and the expectation of an inflation environment above the target throughout the coming year with only gradual improvement in supply constraints, we anticipate stability in interest rates at least through the first half of the year. This is until a noticeable improvement in supply constraints emerges, accompanied by a step-down in the inflation environment towards the target. We share the Bank of Israel’s assessment that the inflation risk is skewed upwards, suggesting that conditions for an interest rate change may arise at the earliest in the second half of 2025. Accordingly, our interest rate forecast ranges from stability to a moderate reduction of up to 50 basis points by the end of 2025.

As expected, the Monetary Committee once again left the interest rate unchanged at 4.50%. The future guidance also remained unchanged, indicating that the interest rate trajectory will be determined by the ongoing convergence of inflation towards the target, stability in financial markets, economic activity, and fiscal policy. The overall tone from the announcement and the Governor’s remarks at the press conference was more optimistic about economic activity, given the decline in the country’s risk premium, but more cautious about inflation, due to inflation stabilizing above the target and the assessment that inflation risk is tilted upwards.

The Committee continued to highlight supply constraints as a factor moderating economic activity on one hand, while contributing to a high inflation environment on the other, partly due to a persistently tight labor market. Nevertheless, it appears that the decline in the risk premium has led to a slightly more optimistic tone regarding economic activity. In addition to raising the growth forecast for 2025, the Committee expects demand surpluses in the economy, which will support inflation growth in the first half of the year (in combination with supply constraints and tax increases), with inflation expected to moderate towards the target only in the second half of the year. However, the Committee continues to see upward inflation risks stemming from geopolitical conditions, supply constraints, currency volatility, and fiscal developments. Consequently, the Governor hinted that, barring significant surprises relative to the baseline scenario, discussions about an interest rate cut will become more relevant only in the second half of the year.

The Governor noted that beyond the relative improvement in the geopolitical situation and a decline in security risks, the reduction in the risk premium was also supported by the passing of the government budget. However, the assessment of fiscal policy was accompanied by a more cautious tone due to concerns that in the final stages of budget approval, some adjustments may be abandoned in favor of a larger deficit. Additionally, there is uncertainty regarding the implementation of necessary adjustments in light of recommendations for military strengthening. The Governor also pointed out issues with the budget composition in terms of growth incentives, the negative implications of not recruiting ultra-Orthodox Jews into military service, and renewed threats from government steps to weaken institutions.

As part of the interest rate announcement, research department forecasts were updated. Growth forecasts for 2024 and 2025 were revised from 0.5% and 3.8% to 0.6% and 4%, respectively. The 2024 forecast was mainly updated due to accelerated activity (primarily vehicle imports) before the VAT increase. This development also contributed to a downward revision of the 2024 budget deficit forecast to 7% of GDP (from 7.2% previously and 7.7% in the last budget update). The 2025 growth forecast includes an expected further decline in the unemployment rate from 3.5% to 3.1% and an unexpected upward revision of private consumption from 7% to 7.5%, despite anticipated moderating effects from government measures. Nonetheless, the inflation forecast for 2025 was lowered from 2.8% to 2.6%, mainly due to the strengthening of the shekel. Following the budget proposal, the public consumption forecast was revised upward to a decrease of only 1.5% (from 4% previously), while the investment forecast was revised downward to 8% (from 12% previously), mainly due to labour constraints in the construction sector. The government deficit forecast for 2025 was revised from 4.9% to 4.7% of GDP, with an expected increase in the debt-to-GDP ratio to 69%. The interest rate forecast was also revised downward, including a moderate reduction of 25-50 basis points to levels of 4.25%-4.0% by the end of 2025, compared to the previous forecast that assumed stability at 4.5% by the end of the third quarter of 2025.

In summary, given the geopolitical and fiscal uncertainties and the expectation of an inflation environment above the target throughout the coming year with only gradual improvement in supply constraints, we continue to anticipate stability in the interest rate at least through the first half of the year. This will be until a certain improvement in supply constraints becomes evident, accompanied by a step-down in the inflation environment towards the target. We share the Bank of Israel’s assessment that the inflation risk is tilted upwards, indicating that conditions for an interest rate change may emerge at the earliest in the second half of 2025. Accordingly, our interest rate forecast ranges from stability to a moderate reduction of up to 50 basis points by the end of 2025.

Authored by:
Rafi Gozlan, Chief Economist, IBI Investment House

Main article photo: The Bank of Israel building Jerusalem. (Reuters/Ronen Zvulun)