JERUSALEM, Jan 1 (Reuters) - The Bank of Israel lowered short-term borrowing rates for the first time in nearly four years on Monday, becoming the first developed country to ease policy, while urging lawmakers to rein in spending that has soared during Israel's war with Hamas.
In reducing interest rates for the first time since April 2020, the central bank cited a stabilization of financial markets since the outbreak of the war on Oct. 7, declining inflation and weaker economic growth.
But Bank of Israel Governor Amir Yaron said the pace of future cuts partly depended on fiscal policy and how Prime Minister Benjamin Netanyahu's government of far right wing and religious parties would keep to responsible fiscal policy.
He told reporters that defense and civilian costs of the war were expected to reach 210 billion shekels ($58 billion) and would be a "budgetary burden" that needed to be dealt with through spending reductions in areas that were not crucial to the war and by raising revenue, usually meaning higher taxes.
"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," said Yaron, who was just approved for a second and final five-year term as governor.
He pointed out the government's inaction so far on making needed budget adjustments - such as cutting back redundant ministries, without giving details of which ministries he meant.
The Finance Ministry estimates a 2024 budget deficit of around 6% of GDP.
"Not acting now ... is likely to cost the economy much more in the future," Yaron added. "What is needed now is a responsible budget that requires adjustments and decisions that are not easy regarding priorities."
Deputy Governor Andrew Abir said that while falling inflation and a recovery in financial markets allowed for the start of rate cuts, the easing cycle would take time due to the war and what will happen with the budget.
"Going forward it's a lot more difficult because there's certainly a lot of uncertainty," he told Reuters. "We're going to likely to be fairly cautious going ahead. We will wait to see how things progress ... There's always a balance between monetary policy and fiscal policy. If fiscal policy is more expansive then monetary policy probably needs to take that into account."
FISCAL POLICY
Finance Minister Bezalel Smotrich praised the rate cut, but seemed to brush aside Yaron's call for budget discipline.
"The responsible fiscal policy that we have been leading for the past year has contributed to the decrease in inflation, and now the lowering of the interest rate serves the need to help the growth of businesses and the economy at the same time as the war," Smotrich said.
Ahead of the rates decision that saw the central bank lower its benchmark rate by a quarter-point from 4.75% to 4.50%, analysts were split, with seven expecting no move and seven projecting a 25 basis point reduction.
It had raised rates 10 straight times in an aggressive tightening cycle that has taken the rate from 0.1% last April before pausing in July and again in August, October and November.
The inflation rate eased to 3.3% in November from 3.7% in October but remained above an annual target range of 1%-3%.
The bank's staff maintained economic growth estimates of 2% for both 2023 and 2024 and set a growth projection of 5% for 2025. Inflation, the bank said, looks set to ease to 2.4% this year, while the interest rate is forecast to gradually fall to 3.75% from 4% by the end of the year.
The shekel weakened 0.6% versus the dollar to a rate of 3.6225 after the rates decision. ($1 = 3.6216 shekels) (Reporting by Steven Scheer and Ari Rabinovitch; Editing by Alison Williams and Louise Heavens)
