Economy of war: Bank of Israel expected to lower interest rates by 0.5%

The Bank of Israel and the Ministry of Finance have already begun formulating scenarios and forecasts related to the loss of domestic product of the Israeli economy, the extent of the expected deficit and debt, as well as the continued planning of the expected economic policy following the war. The great difficulty lies in the uncertainty of the scenario itself. That is, neither the Treasury nor the Bank of Israel know how long the fighting will last, whether it will only include the southern region or whether the conflict will expand to another front in the north.

The Bank of Israel and the Ministry of Finance are unhappy by the amount of extreme predictions - some of which are unfounded - that have been thrown into the air, and therefore quickly began to formulate their own scenarios. The Bank of Israel's baseline scenario takes into account a war that lasts between a month and six months, only in the south and with high intensity.

Given this scenario, according to the Bank of Israel, the damage to the economy is expected to be similar to what we saw in the Second Lebanon War, with one significant difference - and that is the magnitude of the reservists recruited. Between 300,000 and 340,000 reservists have been called up. This recruitment greatly affects the scenario and forecasts as it affects the opening of schools and many businesses. The scenario also includes an assumption that the government will provide the security system with all the funding that will be required to complete the military mission. Therefore, most of the funding will be directed to security, despite heavy budgetary needs also in regards to the reconstruction in Israeli towns near the Gaza border.

It is already clear to the Bank of Israel that the war will have far-reaching consequences, including a permanent increase in the defense budget. Regarding the issue of compensation - it is not expected to be reflected in the budget, since the funds mostly come from the tax authority's compensation fund. Given the base scenario, according to the Bank of Israel, the significant damage to the economy will be concentrated in the last quarter of 2023. Thus, negative growth will be recorded in the last quarter of the year.

The Bank of Israel estimates that, in total, the decrease in gross domestic product will amount to about NIS 20 billion, which is about 1% of GDP, based on a GDP estimate of NIS 1.9 trillion in 2023. The loss of domestic product will occur against a background of a dramatic decline in economic activity and against a background of negative economic sentiment, which will be reflected mainly in the decline in private consumption, the main engine of the economy.

The bank assessed yesterday that it is of the utmost importance to bring a very clear message to the markets, because unlike the pandemic, which was a global event, all eyes are now on Israel: the world expects responsible behavior from Israel, with the expectation being that not all of the budget increase will come from increasing the deficit.

The first estimate of the special budget expenditure for rehabilitation and compensation is NIS 10 billion, which means that over the years 2024-2026, 0.7-0.3 percentage points of GDP must be added to the expected deficit each year. All of this may lead to an increase in the debt-to-product ratio from 59% of GDP to 64%.

According to the Bank of Israel, the government will not be able to finance the entire budget expenditure through increasing the deficit and debt, but will have to divert resources. There are about NIS 9 billion of budget expenditures for the coalition agreements, for example, a large part of which do not support growth. This amount is very similar to the amount that the Bank of Israel set aside - NIS 10 billion - so that if the government diverts those funds, the State of Israel is able to come out of the war without a fiscal scar.

In view of all this, the assessment is getting stronger that as early as next Monday the Bank of Israel will reduce the interest rate by at least half a percent. The central bank of course refuses to comment on anything related to monetary policy, but the estimates are that this is all but inevitable.

The Bank of Israel already intervened in the foreign exchange market last week, and in addition released a comprehensive plan for the banking system in times of war. The forecast now in the markets and among economists is that the Bank of Israel will also use the interest rate tool and ease the financing conditions in the economy.

"In view of the significant negative economic impact of the war on the Israeli economy, and taking into account the drop in the inflation in September, it is expected that the Bank of Israel will soon reduce the interest rate by approximately 50 basis points," explained Dr. Gil Bufman, Chief Economist of Bank Leumi. According to him, "In the future, a further reduction of another 25 bps to the level of 4% is expected. It is possible to reduce the interest rate by a dose greater than 75 bps in the aggregate, but it seems that a significantly larger reduction than 75 bps will require the interest rate to be raised again at a later stage, possibly even above its current level. All of this depends on the continuation of the war and the magnitude of the impact on the economy," he concluded.