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Good afternoon.
We are in the midst of the “Swords of Iron” War, and the State of Israel is facing complex times. Even now, our sons and daughters are at the front, defending us, and I want to express our support and send them our appreciation.
Israel’s economy has strong foundations, and the economic starting point with which we entered the war was positive. The debt to GDP ratio, one of the most important indicators of the economy’s resilience, had declined back to approximately 60 percent, the expected deficit in the budget was low, the unemployment rate was low, and the growth forecast was encouraging, certainly from an international perspective.
The economic ramifications of the war are broad and significant, and they have an impact on overall economic activity as well. The Monetary Committee discussions that were held over the past 2 days focused on the economic ramifications of the war. The Monetary Committee analyzed the various processes and their impact on economic activity and on inflation, and at the end of the discussions, the Committee decided to reduce the interest rate by 0.25% to 4.5%. The interest rate path will be determined in accordance with the continued convergence of inflation to its target, the continued stability in financial markets, economic activity, and the fiscal policy.
I will first survey the state of the economy and the background factors to the Committee’s decision. It is clear to us all that the current economic uncertainty is connected very closely to the security situation and how the war will develop. In view of this, economic developments, including those being outlined by the government, will have an impact on the continuation of the monetary policy. I will expand on that in a bit.
Since the war erupted on October 7th, the Bank of Israel has been holding ongoing situation assessments on the war’s effect on the economy and the markets. We are examining these effects at the economy-wide level, at an industry specific level, and by the size of the various businesses and households. It is clear to us that the adverse economic impact suffered by the economy is substantial and its magnitude varies in different areas. Alongside that, we see recovery in overall economic activity. This is an indication that the Israeli economy is succeeding in adjusting to the reality forced upon us. The continued existence and encouragement of a return to routine to the greatest extent possible on the home front, against the background of the war at the front with the required adjustments, is necessary and essential to the economy.
Inflation in Israel exceeds the inflation target, which, recall, is 1–3 percent. However, in recent months, a continued decline in the inflation rate and its environment is apparent. This moderation is reflected in the inflation of tradable goods as well as in inflation of nontradable goods, which is more “sticky”. In addition, the slowdown in the inflation rate can be seen when examining the dynamics among various time ranges. The decline of inflation impacts on the real interest rate as well, which is still at a positive and restricting level, even given today’s decision.
Furthermore, looking at the inflation forecasts, we see that forecasters estimate that the inflation rate will return to its target over the course of the first quarter. Market expectations for longer terms are also within the target range. These assessments provide us with important information on how market participants see the economic situation and their perception of the monetary policy’s impact on inflation. It is important to remember that expectations are part of the equilibrium and are determined, among other things, in view of the interest rate policy that we adopt, and the credibility that the markets attribute to the Bank of Israel’s monetary policy.
A main factor in its impact on inflation in the coming months will be the foreign exchange market. The high volatility in the shekel exchange rates adds considerable uncertainty. The notable appreciation recently, to the extent that it becomes entrenched, will reduce inflation pressures and will help with its convergence to the target. The policy tools we have implemented so far are consistent with our commitment to return the inflation rate to its target, and the Committee’s assessment is that the current monetary policy supports the convergence of the inflation rate to its target.
Recall that immediately with the outbreak of the war we took several steps with the goal of ensuring full and orderly operation of the markets. These plans have succeeded so far in creating stability in the foreign exchange and financial markets. The high level of the Bank of Israel's foreign exchange reserves, which was around $200 billion just before the war, gives us maneuvering room to work to maintain the economy’s stability, while reducing the uncertainty at this time. To date we have seen that in this market, the balance was successfully maintained. We are constantly following the developments in the market and will act as needed.
Price stability creates economic certainty—it is an essential component in healthy economic activity. In addition, it is important to remember that high inflation adversely affects weaker strata first and foremost. Therefore, returning the inflation rate to its target is our main goal, even at this time. The policy path in the coming months will be impacted by the continued convergence of inflation to its target—but not only by that. The budget policy has a strong impact on economic activity, and likely on financial markets, and thus on the development of prices as well. Therefore, it will also have considerable weight in determining our monetary policy path.
In terms of economic activity—just before the war, the economy was on the verge of a “soft landing”, a gradual slowdown in the growth rate toward the long-term trend, and a moderate relaxing of the tight labor market alongside moderation in the rate of inflation toward the midpoint of the target. After the sharp decline in economic activity with the eruption of the war, the economy began a recovery process as people adjusted to life in the shadow of the war. The economy’s recovery process is relatively rapid but is incomplete. Updated indicators of economic activity and employment point to variation in the extent of recovery. Consumption using credit cards is recovering, but in the tourism industries, for example, the recovery is slow, as expected. The broad unemployment rate, which rose steeply at the beginning of the war, is declining, but here too there is heterogeneity in the decline according to geographical location, type of industry, and size of businesses.
The housing market is very important to the economy. Home prices continue to decline, as have rents in recent months. In view of the adverse impact suffered by the construction industry since the start of the war due to a lack of workers, it is important that the government will continue to act to add additional workers to the construction industry as soon as possible. Beyond maintaining construction activity over the medium range, policies should be adopted to keep the supply of construction high over time. This is the key, as I have noted in the past, to continued moderation of housing prices.
In the domestic capital market, equity indices increased. However, the underperformance since the beginning of the war and over the past year relative to global markets is still notable. Long-term government bond yields declined sharply, against the background of the expectation worldwide for a reduction in the interest rate by central banks. Corporate bond spreads, which widened with the eruption of the war, returned to close to their pre-war level, except for bond spreads of the real estate and construction industries. Alongside that, the economy’s risk premium, as reflected in, for example, CDS contracts, declined from its record at the beginning of the war, but is still at a relatively high level. This is, of course, against the background of the considerable uncertainty still existing around the development of the war.
Globally, in many countries, the inflation environment is moderating even beyond expectations, but is still hovering above the central bank targets. Core inflation, which was “stickier”, is also moderating. There are increasing signs that the monetary tightening is nearing an end, with the US Federal Reserve even signaling 3 interest rate reductions expected during the year. Economic activity in major economies is also continuing to moderate, though there is variation between the US and Europe, the latter being close to a technical recession. In the background, the global manufacturing sector and world trade continue to indicate weakness. As a small and open economy, we are of course impacted by these developments and align our policy with the appropriate balance between domestic developments and developments worldwide.
These issues and others are taken into account in the updated macroeconomic forecast published today by the Research Department. The current forecast was built under the assumption that the direct economic impact of the war reached its peak in the fourth quarter of 2023, and will continue to the end of 2024 but at a declining magnitude. For 2025, the assumption is that there will not be additional substantial security impacts. Similar to previous forecasts, the current one assumes that the lion’s share of the war will occur on one front, Gaza. It is clear that the length of time, and the developments of the war to additional areas, can change the estimates markedly. In line with these assumptions, the Research Department kept its growth forecast at 2 percent for each of 2023 and 2024, and at 5 percent for 2025. It is important to emphasize that this growth rate reflects convergence from below to the pre-war GDP growth path forecast. According to the forecast, the broad unemployment rate is expected to be 5.3 percent, on average, in 2024, and 3.2 percent in 2025. Year over year inflation is expected to be 2.4 percent in the fourth quarter of 2024 and 2 percent in the fourth quarter of 2025. In addition, the Research Department’s forecast assesses that the interest rate will be 3.75/4 percent, on average, in the fourth quarter of 2024—a more moderate path of decline than that assessed by the market.
The forecast assesses that the budgetary costs of the war, expenditures plus loss of income, are expected to total about NIS 210 billion. Moreover, the forecast assumes a permanent annual increase in defense expenditures after the war, of about NIS 20 billion. In addition, to this amount are added long-term expenditures including the rehabilitation of the communities adjacent to Gaza and an increase in interest expenses, so that the total increase will reach approximately NIS 30 billion per year. To fund these increases, the Department estimates that the government will make cumulative adjustments to the budget, of a permanent nature, that by the end of 2025 will reach an annual scope of approximately NIS 30 billion. Ideally, these adjustments should be set out already in 2024 and a marked share of them will be realized this year already. This adjustment will lead the debt to GDP ratio, one of the most significant fiscal indicators, to an expected 66 percent of GDP at the end of 2024 and 2025. Going forward, these adjustments will allow a desired path of a declining debt to GDP ratio, so that in 2030 this ratio will decline to approximately 63 percent. It is important to note that the government still has not established its fiscal targets for 2024. The Department’s forecast also presents the implications if the required adjustments are not made, in which case the debt to GDP ratio will continue to increase over time at a notable rate.
As I have already noted, the Israeli economy is fundamentally robust and it has the characteristics needed to prosper even while waging the war. However, this does not occur on its own. The policies that will be adopted to deal with the numerous difficulties will have a decisive impact on the economy’s ability to return to rapid growth. The government should adopt the budget processes required to deal with the costs of the war and with the increased defense budget in the coming years in order to return the economy as rapidly as possible to a path of sustainable growth and not to deteriorate to lost years. The principles for that are clear: focusing on the expenses of the war and expenditures that are growth drivers, while cutting nonessential expenditures, certainly those that do not support growth.
The defense and civilian costs of the war total around NIS 210 billion, and are certainly a budgetary burden. While this is a transitory increase, the future defense budget is expected to grow on a permanent basis. In view of the macroeconomic impact of the defense budget, this increase should also be examined from an overall view with an ongoing requirement of the defense system to increase its efficiency. As part of this, a broad public committee, military and civilian, should formulate a new multiyear framework for the defense budget. In any case, this permanent growth in expenditures highlights even more the need for adjustments in the budget and the setting of a deficit at a level that will lead to a decline in the debt to GDP ratio in the years after the war. A possible way to accomplish this is by adjustments, both on the expenditures side and the income side in items of a permanent nature and in the size of the increase in permanent expenditures.
The government should guide its policy with these principles in order to maintain the credibility of fiscal policy in the eyes of the markets and the public. This is also in order to ensure the required preparation for additional crises that Israel is liable to face in the future. A marked portion of the above adjustments should already be made in the 2024 budget. This is part of the seriousness of government policy that the markets need to see. What is important is not only how much the deficit will be in 2024 itself, but what the markets will conclude from it and from the government’s decisions in the budget area, regarding the future path of the debt. If the markets perceive that Israel is moving toward a prolonged path of rising debt it is likely to lead to increased yields, depreciation and inflation, such that a higher central bank interest rate will be required. In markets, the negative response effect is not always linear. It is difficult to predict when the inflection point will occur, when the markets will reprice this risk, but to the extent that these adjustments are not made, the probability of that increases. I would like to say as clearly as possible: not acting now to adjust the budget via cuts in expenditures, removing redundant ministries and increasing revenues in view of the needs of the war is likely to cost the economy much more in the future. The cost will be reflected not only in the areas of the budget and the deficit, but is liable to have a negative impact on additional economic processes. It is not for nothing that the phrase “there are no free lunches” is common in economics. In this regard, an increase in the country’s debt will result in one or more of the following: reducing expenditures, increasing revenues, tax in the form of interest on the debt or inflation tax. In addition, as in many other cases in life, what gets pushed off now ultimately ends up costing much more and requires greater effort and pain later on. Therefore, what is needed now is a responsible budget that requires adjustments and decisions that are not easy regarding priorities. To the extent that these are made, the conditions required for the Israeli economy’s return to its high potential growth will prevail.
In closing, there is no doubt that we are going through a challenging period. We will continue to assist Israel’s economy to get through the existing challenges and those yet to come. I would also like to convey from here that the Bank of Israel and the Monetary Committee extend our condolences to the families of those killed, we wish for a full recovery for the injured, and we hope for the speedy return of the captives and the missing. Our thoughts are with you.
Thank you.