The Monetary Committee of the Bank of Israel will be meeting next week to discuss the decision regarding the interest rate. Up until a few days ago, the market’s expectation was that there would be a 0.25% increase. However, the recent developments on the political stage and the risks arising from the judicial reform continue to weaken the shekel relative to the U.S. dollar. This newly developing trend may persuade the Bank of Israel to hike the rate by more than was originally planned.

As the majority of imported goods into the country are denominated in U.S. dollars, a further devaluation of the shekel may cause an inflationary spike. This will necessitate the Bank of Israel increasing the current rate of 3.75%, the highest level since 2008, by an additional 0.5% as opposed to the anticipated increase of 0.25%.

According to experts, the shekel’s weakness is fuelled by political instability and speculation regarding capital outflows. Approximately 37 Israeli organizations have already arranged to transfer their funds abroad. And if the January CPI shows no signs of decelerating inflation, there is a strong possibility that the interest rate will increase by 0.5%.

According to Alex Zabezhinsky, chief economist at Meitav Dash, there is an additional factor signalling a change in the forex dynamic: the dissonance between the USD/NIS exchange rate and the movement of the U.S. stock market. In the past, when key U.S. market indices increased in value, the shekel appreciated against the dollar because Israeli institutional investors had to purchase shekels to hedge their American positions. And what we see now is the exact opposite, with the NIS losing ground against the USD despite Wall Street’s strong start to the year.

The shekel’s resilience was one of the factors that attracted foreign investment. Therefore, if it continues to decline in the near future, the Israeli capital market may lose its allure.

However, not everyone is pessimistic. Psagot chief economist Ori Greenfeld concurs that the depreciation of the shekel is one of the causes of the rise in inflation. Nevertheless, rising bond yields are pushing in the opposite direction. Therefore, it is possible that the Bank of Israel will refrain from taking a more aggressive stance when it decides on interest rates next week.

Having said that, if the government chooses to reach a compromise or even abandon its plans for radical judicial reform at this stage, stability will return to Israel’s financial market very quickly. Domestic politics should be focused on preserving economic stability in a world where higher inflation is likely to persist in the near future and geopolitical risks abound. Otherwise, if current issues are not addressed in a timely and orderly fashion, the consequences could be serious.