The Bank of Israel has decided to keep the interest rate steady at 4.5% for the fifth consecutive time, navigating a challenging economic landscape marked by global and domestic uncertainties. This decision, while maintaining consistency, highlights a significant shift in the bank’s approach, particularly in contrast to other central banks that have begun signaling potential interest rate cuts.

When the Bank of Israel transitioned in 2016 from monthly to eight annual interest rate decisions, the primary objective was to align with global practices, akin to those of the Federal Reserve in the United States and the European Central Bank. This change simplified the monetary committee’s task, often resulting in decisions that mirrored the actions of the U.S. Fed. In an interconnected world, where capital flows seamlessly across borders, synchronizing interest rates with global trends was logical and necessary.

However, the past few months have disrupted this alignment. As central banks worldwide, including the U.S. Fed under Jerome Powell, begin to outline plans for reducing interest rates, the Bank of Israel, led by Governor Prof. Amir Yaron, finds itself in a unique and constrained position. Unlike his global counterparts, Yaron is unable to follow suit.

In January 2023, when inflation was expected to drop to 2% by 2025, Yaron preemptively reduced the interest rate by a quarter percent to 4.5%. At that time, he projected that the rate would further decrease to 3.75% or possibly 4% by the end of the year. However, as inflation surged to 3.2% in July, higher than the U.S. rate of 2.9% and beyond Israel’s target of 1-3%, it became clear that lowering the interest rate further would exacerbate inflationary pressures. The latest forecasts suggest that inflation will hit 3.8% by January 2025 and will only begin to approach the upper target range by mid-year.

Inflation’s impact on borrowers is particularly severe. Many loans in Israel are indexed to inflation, meaning that rising prices inflate debt beyond regular monthly repayments. This creates a difficult environment for debtors, even as interest rates remain unchanged.

The gap between Israel’s interest rates and those of the U.S. is also a cause for concern. While Israel’s official rate is currently lower than the U.S. Fed’s average rate of 5.5%, the yield on Israeli bonds is significantly higher, marking an 11-year peak. This discrepancy highlights the broader economic instability driven by security concerns, political upheaval, and social unrest, all of which have contributed to a decline in investor confidence.

Governor Yaron, aware of these challenges, has refrained from adjusting interest rates further and is instead focusing on urging the government to reduce its budget by NIS 30 billion. Without such fiscal discipline, his ability to manage the cost of money effectively is severely limited.

This situation is reminiscent of the early 2000s when the Bank of Israel rapidly lowered interest rates in response to a global economic crisis and the outbreak of the Second Intifada. The intention was to stimulate the economy, but the result was a severe economic downturn, forcing the bank to hike rates back up within months. The current scenario, though different in many respects, echoes the same challenges: economic instability fueled by a lack of fiscal discipline.

The Israeli public, seemingly aware of these economic realities, has adjusted its financial behaviour. In July, a significant portion of new mortgages were taken out at fixed interest rates, reflecting a preference for stability amidst uncertainty. Meanwhile, the share of mortgages linked to the consumer price index has declined, despite the lower interest rates offered on these loans. This shift suggests that expectations for a return to low inflation and interest rates are dim, with high inflation and elevated borrowing costs becoming the new normal.

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