Navigating Israel's Monetary Crossroads: Geopolitical Risks, Inflation, and the Path to Rate Cuts

The Bank of Israel's decision to hold its benchmark policy rate at 4.5% in July 2025 underscores a fragile equilibrium between domestic growth, geopolitical volatility, and inflationary pressures. With inflation hovering just above the upper limit of its 1%-3% target and global risks lingering, the central bank has entered a prolonged “wait-and-see” phase. This stance creates a complex backdrop for investors, requiring a nuanced approach to currency, bond, and equity strategies.

Geopolitical Risks: A Persistent Drag on Stability

The unresolved Gaza conflict and the recent Iran ceasefire have left Israel in a state of heightened uncertainty. While Operation Rising Lion reduced geopolitical risk premiums post-October 2023, they remain elevated compared to pre-crisis levels. Analysts note that persistent tensions could disrupt trade flows, delay investment, and keep inflation elevated through supply-chain pressures.

The Bank of Israel's caution is evident in its revised 2025 GDP growth forecast, lowered to 3.3% from 3.5%, though it raised the 2026 outlook to 4.6%. This signals recognition that growth may remain uneven until geopolitical risks abate. For investors, this means export-oriented sectors—such as technology and manufacturing—could face headwinds due to the shekel's 6%-8% appreciation against major currencies, which reduces their competitiveness abroad.

Inflation Dynamics: Headline vs. Core

While headline inflation in May 2025 remained stubbornly above target at 3.1%, core inflation (excluding volatile government interventions) cooled to 2.5%, within the central bank's target range. This divergence highlights the Bank's dilemma: headline inflation is still being driven by geopolitical-driven supply imbalances, while core inflation reflects underlying economic conditions.

The Bank's focus on convergence to the target range suggests it may wait until headline inflation stabilizes before cutting rates. However, declining risk premiums—a byproduct of reduced immediate conflict risks—and the shekel's strength could ease imported inflation pressures over time.

Rate-Cut Timing: The “Wait-and-See” Trade

Despite the July hold, markets are pricing in potential rate cuts as early as August or September 2025, driven by expectations of further cooling in core inflation and fiscal consolidation. The Bank's own projections suggest a gradual decline to 3.75% by Q2 2026, contingent on inflation and geopolitical risks.

Key risks to this path include:
1. Labor market tightness: Unemployment at 2.8% and wage growth exceeding 4% could reignite inflation.
2. Global policy divergences: If the U.S. Federal Reserve halts its easing cycle, it could limit Israel's room to cut rates.
3. Fiscal slippage: With the deficit projected to hit 4.9% in 2025, fiscal discipline remains critical to maintaining credibility.

Market Implications: Opportunities and Caution

Currency: The shekel's appreciation has been a double-edged sword. While it eases import costs, it harms export-heavy industries. Investors might consider shorting the shekel against currencies of trade partners (e.g., USD or EUR) if geopolitical risks escalate further.

Bonds: With yields on Israeli 10-year government bonds at 4.2%—a premium over global peers—the market is pricing in limited rate cuts. However, the Bank's eventual easing could push yields lower, making long-dated shekel-denominated bonds attractive for yield-seeking investors.

Equities: Defensive sectors like healthcare and real estate appear resilient. Israel's aging population and urbanization trends support demand for healthcare services and residential real estate. Meanwhile, growth-sensitive sectors such as technology and industrials face risks from currency strength and delayed investment.

Conclusion: Patience Pays Until Q3 2025

The Bank of Israel's “wait-and-see” approach demands investors remain selective. Shekel bonds and defensive equities offer stability, while growth-oriented plays should be delayed until clearer signals emerge post-Q3. Geopolitical risks remain the wildcard, but with inflation cooling and risk premiums declining, the path to rate cuts is still intact—albeit gradual. Investors who balance caution with opportunism stand to capitalize on this pivotal moment.

Stay vigilant, and position for the easing cycle ahead.