(Bloomberg) -- Israel refrained from cutting interest rates on Monday, with the central bank focusing on protecting the shekel and cooling inflation expectations as the war in Gaza causes defense spending to surge.

The Bank of Israel’s Monetary Policy Committee left its key rate at 4.5% for the second consecutive meeting. Only a narrow majority of analysts, including JPMorgan Chase & Co., predicted the move. The others expected a cut of 25 basis points.

The shekel extended its gains after the decision. It rose 2.1% to 3.69 per dollar as of 5:50 p.m. in Tel Aviv, heading for its best daily performance this year. It’s reversed all the losses it suffered last week when Iran’s threat to retaliate against Israel for a deadly missile strike on one of Tehran’s embassy buildings in Syria unnerved markets.

“In view of recent developments, which indicate a substantial increase in the geopolitical uncertainty, the Monetary Committee decided to side with caution and kept the interest rate unchanged,” Governor Amir Yaron said in a speech.

Israeli assets, including stocks, were already rallying on Monday, in part because of optimism over a potential cease-fire deal with Hamas that would involve the release of Israeli hostages and Palestinian prisoners.

Despite inflation of just 2.5% year-on-year, the central bank weighed how there’s little certainty over when the war in Gaza will end and how tensions with Iran and its main proxy group, Lebanon-based Hezbollah, are worsening.

The government’s ramped up spending and borrowing to fund the conflict. Israel’s 12-month trailing fiscal deficit reached 6.2% of gross domestic product in March, the finance ministry said earlier on Monday. Expenditure between January and March was 38% higher than during the same period last year.

The government envisages a fiscal shortfall for this year of 6.6% of GDP, which would be one of the widest gaps for Israel this century.

The increase in spending and a drop in the shekel this year have contributed to a rise in inflation expectations in recent months. Two year break-even rates have climbed to 3.2%, above the central bank’s target range of 1% to 3%.

Yaron has repeatedly said he’s concerned about fiscal policy and that it will be an important factor in determining monetary policy. The government’s mostly ignored his calls for a committee to discuss defense priorities and spending.

The governor said in his speech that he’s watching the movements of other central banks around the world, especially given Israel’s status as a small and open economy.

That suggests he doesn’t want the gap between Israel and the US’s interest rates widening too much, lest it discourages capital inflows and puts more pressure on the shekel.

Israel’s base rate is 1 percentage point below the upper bound of the US Federal Reserve’s key rate, the biggest difference has been since 2022.

The Israel economy’s experienced an uneven recovery from the first few weeks of the war, which erupted when Hamas attacked from Gaza on Oct. 7. Many industries, including construction and tourism are still suffering, even as credit-card spending rebounds.

“Geopolitical uncertainty remains high, and recently has been increasing,” Yaron said. “Despite the gradual improvement in economic activity, there is a long way to go until the economy fully recovers.”

(Updates with more details.)

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