Israel's Shekel Strength Spurs 25-Basis-Point Rate Cut to 4.25%

Israel's Central Bank to Resume Rate Cuts After Two-Year Pause

Israel's central bank will cut interest rates by 25 basis points to 4.25% on Monday, ending a two-year pause amid signs of economic stabilization following a U.S.-brokered ceasefire in Gaza. The Bank of Israel has kept rates steady since January 2024, but inflation has now remained within the target range of 1% to 3% for three consecutive months. Policymakers are cautiously optimistic that the truce will ease supply chain bottlenecks and help bring down inflationary pressures.

The decision marks a key shift in monetary policy, as the central bank seeks to balance economic growth with inflation control. The shekel has gained more than 13% against the dollar over the past year, reinforcing confidence in the currency and reducing inflation expectations. Bank Hapoalim, Israel's second-largest lender, has lowered its inflation forecast for 2025 to 1.7%, citing a "gradual shekel effect" on imported goods.

While a rate cut is widely expected, analysts warn that risks remain. The Israeli economy grew 12.4% in the third quarter, far outpacing expectations, but annual growth is still projected at 2.5%, below pre-war levels. Tight labor markets and strong fiscal expansion continue to pose inflationary threats, prompting the central bank to maintain a cautious stance.

Why the Rate Cut Is Happening

The resumption of rate cuts reflects growing confidence in Israel's economic resilience following the Gaza ceasefire. Inflation, which hit over 6% in early 2024, has steadily declined to 2.5% in October, within the central bank's target range. This improvement has been attributed to a stronger shekel and easing supply chain pressures, as well as the impact of fiscal and monetary policies according to Bloomberg reports.

The Bank of Israel has been closely monitoring the effects of the truce, which has reduced uncertainty in the financial markets. The central bank's cautious approach has been driven by the risks of renewed hostilities and the broader war costs, which are expected to reach 350 billion shekels by the end of 2026. With the ceasefire stabilizing the region for now, the central bank sees an opportunity to test the waters with a modest rate cut.

The decision also aligns with broader global trends. Central banks in developed economies have increasingly shifted toward easing monetary policy as inflation comes under control. Israel's move signals that policymakers are prioritizing growth over tightening, while remaining vigilant about the risks posed by geopolitical instability according to financial analysts.

Risks to the Outlook

Despite the positive signs, the Bank of Israel faces several challenges. Tensions with Hezbollah in Lebanon have flared in recent weeks, with Israeli airstrikes killing senior Hezbollah officials in Beirut. These strikes, despite a U.S.-brokered ceasefire, highlight the fragile security environment and the potential for renewed instability.

The central bank will also need to monitor the impact of Israel's large fiscal deficit. The government has spent heavily on defense and reconstruction efforts since the war began, with fiscal expansion likely to persist. This could fuel inflation through higher demand and tighter labor markets. While the third quarter GDP growth of 12.4% is impressive, annual growth is expected to remain below the pre-war trendline of around 3.5%.

Analysts suggest the central bank will adopt a data-dependent approach moving forward. Morgan Stanley's Georgi Deyanov noted that the bank is likely to issue "cautious, meeting-by-meeting guidance," reflecting the uncertain economic outlook. The path of inflation, exchange rate stability, and geopolitical developments will all play a role in shaping future monetary policy.

What This Means for Markets

The rate cut is expected to boost financial markets, particularly in the local currency. A lower interest rate environment typically supports equity valuations and increases liquidity, which could benefit Israeli banks and exporters. Bank Leumi and First International Bank have both reported strong third-quarter results, with non-interest income rising sharply.

However, investors should also consider the risks associated with geopolitical instability. While the central bank has signaled a more accommodative stance, ongoing tensions with Hezbollah and the broader regional conflict could disrupt economic growth. The U.S. and Israel continue to push for a long-term solution in Gaza, but progress has been limited amid resistance from Hamas and other militant groups.

For global investors, Israel's rate cut signals a potential shift in emerging market policy trends. As central banks around the world consider easing, investors may look to emerging economies for higher returns. However, the political and economic risks in Israel and the broader Middle East mean that caution is warranted.