Another six months of war between Israel and Palestinian militant group Hamas in Gaza would reduce Israel's economic growth by a half point in 2025 and further raise the debt burden, Bank of Israel Governor Amir Yaron said on Tuesday.
A day after keeping interest rates unchanged again after a January 2024 cut, Yaron said monetary policy needs to remain "cautious" given the uncertain geopolitical situation and near-term inflation environment, with policymakers ready to delay any rate cuts until inflation eases.
After a 1% pace of economic growth in 2024, the Bank of Israel projects 3.5% growth this year - assuming the war in Gaza winds down. But Israel has stepped up air strikes and ground forces have taken control of parts of Gaza, in its bid to eliminate Hamas and bring back remaining hostages held there.
"The war, in terms of its effect on the economy, is particularly through the labour market right now," Yaron told Reuters on the sidelines of the Israel Democracy Institute annual economic conference, referring to citizens called up for military reserve duty, during which they would not be working.
The central bank had assumed that the rate of reservists being called up would start declining in the second quarter.
However, "right now, we are seeing the opposite," Yaron said. "If ... there is intensification of the war in Gaza for another six months that's already going to shave a half percent more in terms of growth in 2025," and raise the debt-to-GDP ratio to 71% from 69%.
In the longer term, Yaron said he hoped the economy would revert to its long-term potential of annual growth of 4%.
The Bank of Israel's economists also project the benchmark interest rate to fall to 4% from 4.5% by early 2026 on hopes for easing inflation. The inflation rate rose to 3.6% in April from 3.3% in March to stay above a target of 1-3%.
Based on bond yields, financial markets still expect inflation to ease to 1.8% in the coming year.
Yaron said he hoped supply - constrained by the war - and demand will come more into balance and push inflation down, but given the fluid situation, policymakers are putting less weight on near term inflation expectations.
"If we don't see some of those (inflationary) corrections, it might take a little bit longer (to lower rates). And if it does take longer, we will stay restrictive for longer," he said.
Should the recent appreciation of the shekel be sustained, that would help to ease inflation, he said.
