Bank Discount with a forecast: Is the interest rate in Israel on the way to a change?

Is the Bank of Israel facing a change of direction in interest rate policy? A macroeconomic review by Shmuel Katzvian, chief strategist at Bank Discount, points to a significant gap between the current interest rate level and the state of inflation and growth in the Israeli economy. According to him, the interest rate is still relatively high for the current background conditions, which may pave the way for further interest rate cuts during the coming year.

The next interest rate decision by the Bank of Israel, expected on September 1, is not yet determined. The two main scenarios are keeping the interest rate at the current level or a reduction of 0.25%. According to the review, the interest rate market currently prices in a 46% probability of a reduction. The decision is expected to be influenced by recent developments in the shekel exchange rate, Israel's risk premium, capital market conditions, and global economic data.

However, at Bank Discount they are looking beyond the next decision. The bank estimates that the interest rate reduction process in Israel has not yet ended, and that at least two reductions are expected during the coming year. This contrasts with the market, which currently prices in a scenario of only one reduction. The bank emphasizes that it is difficult to determine the timing of the reductions in advance, as each decision will be made in accordance with the data available to the Bank of Israel at that time.

The review also presents a historical comparison between the interest rate, inflation, and growth. The current interest rate of 3.5% is at the 72nd percentile of the last two decades and at the 64th percentile of the last ten years. On the other hand, annual inflation is only 1.5%, a figure that is at the 45% to 47% percentile in historical comparison, indicating a significantly more moderate inflation environment.

Growth data also present a complex picture. In the last quarter, an impressive annual growth of 15.4% was recorded (or 14.4% excluding production abroad). However, at Bank Discount they explain that this figure is largely influenced by the recovery after the crisis of October 7, 2023, and the low starting point. When examining the cumulative real growth over the last three years, it amounts to only 8.4%, a figure that is at a low percentile of 8% to 15% in historical comparison.

This means that according to the analysis, there is a gap between monetary policy and the state of the economy. On one hand, the interest rate is at a relatively high level, and on the other hand, inflation is moderate and cumulative growth is weak. At Bank Discount, they estimate that the inflation forecast for the coming year, which stands at 1.7%, strengthens the assessment that the interest rate is expected to fall at least twice.

These decisions have direct significance for households and businesses. The Bank of Israel interest rate affects the prime rate, and therefore an interest rate drop may reduce financing costs for borrowers, including mortgage and loan holders. For businesses, a decrease in the cost of credit may facilitate cash flow and allow for increased investments, hiring employees, and continued recovery. The gap between the estimates may be significant for the bond, stock, and real estate markets, where interest rate changes have a wide impact.